Markets endured a difficult period in October amid big setbacks in global equities and volatility re-emerging more broadly across all asset classes. In our view, this reflects a perception that we are now past the peak for global economic growth and US earnings, with few positive catalysts on the horizon.
This recent turbulence marks a departure from what we have seen in the first nine months of 2018 and we expect this to be a reasonably difficult transition period. However, we do not think the bull market is over, just that markets are going to take some time to stabilise and in order to start recovering we need to see leadership from parts of the market that thus far have lagged – ie value stocks or markets such as Europe, Japan and emerging markets – the US can no longer be relied on to provide this. Ultimately, we believe equity markets will be better going forward but this is going to take some time.
Regarding monetary policy, we expect the Federal Reserve (Fed) to keep its current policy stance and policy language intact, which suggests a quarter point rate hike at the upcoming Federal Open Market Committee meeting in December, another in the Spring and a further two in 2019. This aim is obviously conditional on broader economic data – which has been resilient, with inflation now at the Fed target – and we do not expect recent market volatility to prompt any deviation from that course of action.
The European Central Bank (ECB) is in a slightly different position; economic data across the eurozone has been disappointing, although headline inflation is now at the ECB's target. The central bank has indicated it will conclude its asset purchasing programme at the end of this year, with an interest rate rise deemed likely in the third quarter of next year. That said, it is possible a rate adjustment could be brought forward if inflation overshoots.
There is little doubt that generating returns from markets has become more difficult and therefore minimising drawdown risk has come into focus from a multi asset and portfolio construction point of view. To us, this requires the use of alternatives and non-directional strategies to complement more traditional directional positioning in stocks and bonds.
In our view, opportunities can be found in areas such as alternative risk premia, rolling down curves, credit and commodities. We believe there will still be alpha generating opportunities in equity markets, given a greater dispersion of returns, and we are moving back into emerging markets and financials in Europe, albeit on a fairly small scale.
From an asset allocation perspective we no longer believe in a 60% stocks / 40% bonds world and our allocations towards equities are at a more modest 30%; fixed income and specialty credit exposure is also around 30%; while we hold about a 40% weighting in alternative sources of return.
Overall, we expect the return environment to be more modest and calibrated going forward, but we do think there are opportunities.
The US mid-term elections will take place on the first Tuesday in November and have been widely anticipated by a number of observers, including capital markets. Polls are currently indicating that the Democrats will regain control of the House of Representatives, but will fall short of capturing the Senate (as well as making some gains at a local State level) which suggests there will be a divided government for the next two years in Washington. On this basis we are anticipating gridlock across the policy setting framework, which implies recent policy accomplishments, such as tax cuts and deregulation, will remain in place.
Gridlock may actually prove to be a good thing for markets in the sense that there might not be as many negative surprises on the policy-making front; however, the president will still exert essentially unlimited power on international affairs, particularly around the settings of tariffs, meaning the trade conflict with China is unlikely to go away. Recent rhetoric shows there is still potential for this to escalate further, with another round of items being proposed for tariffs or those tariff rates rising in the early part of next year. This is an area that will not be affected by the mid-terms but markets will be watching very closely over the coming months.