Following the strong advances of global equity markets in the first weeks of 2019, we anticipate the rally will continue provided the US and China can find agreement on trade. While there is room for the market to run further, we have now recovered much of the ground lost in the fourth quarter of last year. Major indices are back at early Q4 levels and are beginning to look a bit stretched now relative to the weaker global growth backdrop that has also emerged.
Fixed income markets, on the other hand, have not moved back to the levels that prevailed before the Q4 2018 turbulence. Eventually we believe they will, but presently investors do not anticipate the Federal Reserve (Fed) will hike again this year. However as confidence returns to markets and the broader economy, it will not be long before the market has to reconsider whether the Fed will have to nudge up rates again. I think it is likely that we will see bond yields moving higher later this year reflecting unfinished business by the Fed.
Assuming trade and other political risks remain subdued, the greatest opportunity is in emerging markets. They are most exposed to global trade, so a reduction of trade tensions would disproportionately be of benefit to them. Also, China is trying to stimulate its economy. Typically Chinese stimulus spills over positively in emerging markets. Other beneficiaries include Japan, which is in the midst of a secular improvement in return on equity. Although Japan has lagged at the beginning of this year, its market has long-term potential and we believe it will find its footing again.
Europe could also surprise. Europe is out of favour. It is the least loved market among investors. Yet for precisely that reason it has potential to surprise to the upside. Weakness in European growth last year was, in part, due to special factors which we believe are likely to recede in importance, for example disruptions to the German automobile industry or to transportation. As those effects fade, growth could pick up more than expected, helping to lift earnings expectations.
Despite the generally favourable outlook for risk assets at the beginning of this year, we must also recognise that the turbulence at the end of 2018 is a harbinger of things to come.
We have arrived in a post-peak world where growth is slowing and where global earnings growth is also weakening. Against that backdrop, risk matters more than it did when things were improving. Consequently, capital markets will remain vulnerable to jitters about political or policy risk.
Taken together, risk-adjusted returns could be significantly lower in the year to come than experienced over the past decade. Volatility is likely to recur more frequently and correlations will likely become less predictable. Diversification, in short, becomes more important.
How should investors diversify? We believe a modest exposure to global equities and fixed income, combined with more significant allocations to non-directional strategies and cash are the building blocks of diversified portfolios.
In our view, such portfolios ought to be better able to withstand the shocks that will inevitably recur in capital markets in a post-peak world.