At our latest monthly asset allocation committee meeting the members discussed the state of markets at the beginning of 2019, with a focus on the opportunities for tactical asset re-allocation.
Two broad conclusions emerged from the discussion. First, all members agreed that markets had over-reacted, particularly during the period of greatest volatility in mid-December. Equities were oversold, safe-haven government bonds overbought. As a result, tactical re-allocation opportunities are on offer as market sentiment normalises.
That is also the message from various models and indicators we follow. In contrast to uniform ‘risk off’ signals during much of Q4 2018, the picture is now more mixed. Our earnings-based models are ‘cautiously bullish’, whereas various sentiment and positioning metrics confirm that investors had adopted extreme levels of bearishness late last year.
The second conclusion is that the ongoing recovery of risk assets should be seen as a temporary recalibration, bringing asset prices back in line with the fundamentals, rather than the beginning of longer trends. Put differently, the underlying thesis of a ‘post-peak’ world, characterised by decelerating global economic and earnings growth, remains intact. As a result, we believe the medium-term prospects for asset returns remain modest and in all likelihood will be accompanied by episodes of higher volatility over the course of 2019.
Accordingly, the committee continues to place emphasis on proper portfolio construction and risk mitigation. Within equities, the preference remains for allocations to quality, low volatility, earnings visibility and proven business models, rather than to ‘value’ or ‘cyclicals’. Over time, we believe growth at a reasonable price is likely to deliver greater return per unit of risk than most other equity allocations. From a geographic perspective, the US and Japan are preferred to Europe or the UK, where earnings and policy risk (Brexit) are higher. In our view, emerging markets are likely to benefit from a stable-to-softer US dollar (see below).
Other asset classes offer select potential opportunities. High yield represents a tactical option as excessive cyclical risk premiums recede. But, over time, we believe mortgage-backed and insurance-linked securities are likely to offer greater portfolio stability and return predictability. In some portfolios, we have increased allocations to convertible bonds as well. Overall, we prefer short duration, either relative to benchmark in long only strategies, or outright in long / short portfolios.
Alternatives continue to struggle and in various portfolios we have pared back allocations significantly. Low volatility target return approaches remain one way to gain exposure to non-directional risk with low beta to either equities or fixed income, ie with clear diversification benefits.
Finally, the committee anticipates a stable or possibly even weaker US dollar during the first months of 2019. The Fed’s latest language of ‘patience’ has all but removed the prospects of Fed rate hikes in 2019 and, barring an unexpected acceleration of US growth or inflation, has resulted in modest dollar depreciation, particularly versus the yen. A weaker US dollar, if accompanied by a recovery of commodity prices, should benefit emerging bond, equity and currency markets.
The meeting concluded with a discussion of risks to our base case, including:
1. Political disruption, either in the form of a ‘hard Brexit’ or an unanticipated escalation of global trade conflict, could easily tip markets back into the extreme ‘risk off’ environment of late 2018.
2. An unanticipated acceleration of inflation, particularly in the US, would likely quickly remove a recent source of support for markets, namely expectations that the Fed rate hiking cycle is coming to an end. Unlike the Q4 2018 episode, however, accelerating inflation would likely undermine stocks and bonds simultaneously, potentially creating adverse trading conditions for credit fixed income as well.
3. On the positive side, we cannot exclude the possibility of a ‘melt-up’ in risk assets, particularly if signs emerge that pessimism about European growth and earnings proves excessive. Europe has the potential to be the big contrarian surprise for 2019, even if the prospects of that materialising soon seem small.