During the second quarter of 2018, investor conviction faded, producing directionless markets accompanied by bouts of volatility. Following the attainment of cyclical peaks in May, global government bond yields (with the exception of Italian government debt) generally fell as investors trimmed allocations to equities, credit and emerging markets. As a consequence, yield curves flattened, contributing to renewed weakness in value styles, but also giving a lift to previously beleaguered interest rate sensitive sectors, such as REITs and utilities. The reversal of many popular pro-cyclical trades contributed to poor performance among many active managers, further undermining investor confidence. Trend-following strategies also struggled against the backdrop of oscillating bond and equity markets.
Among the fundamental factors eroding market performance was the escalation of trade conflict. As it became apparent that European and NAFTA trading partner efforts to mollify the Trump Administration were unlikely to work, positions hardened, leading to concerns of a tit-for-tat escalation, as did China’s hard line stance. From a sector perspective consumer discretionary, luxury and auto sectors were among the hardest hit by trade war fears, as were trade-exposed segments of emerging markets. The latter also suffered against the backdrop of US dollar strength.
Still, markets avoided an outright freefall. Bond yields settled in at lower ranges, but did not breach key technical levels. The US and Japanese equity markets managed to move somewhat higher by the end of the second quarter. In large part, that is because despite heightened concerns about trade conflict, global growth remains resilient. Indeed, the US and Japanese economies are showing signs of renewed vigour at mid-year, as evidenced in the most recent ISM surveys and June employment report. Against that backdrop, equity analysts remain broadly upbeat about the upcoming Q2 earnings season.
In short, investor confidence has been sapped by a sharp turn from US business-friendly policies in 2017 (tax cuts, deregulation) to a populist anti-trade fusillade of 2018 that appears unlikely to abate before the US mid-term elections in early November. The reversal of various consensus positions (long emerging equities, long overall equity exposure and short duration) has also hurt performance and eroded manager risk appetite.
Against this backdrop, the asset allocation committee had already adjusted portfolios in early 2018 to address some of the risks that subsequently unfolded. In most strategies, equity allocations were trimmed in early Q1 2018 in favour of shorter duration credit and cash holdings, with an emphasis on capital preservation. Low correlation fixed income holdings have proven popular in various managed portfolios. Unfortunately, non-directional strategies, including equity long/short, have proven less rewarding (correlated to overall market moves), particularly for emerging market long/short managers.
Starting from a cautious approach, the committee feels it is unwise - absent a significant geopolitical or growth shock - to reduce risk further. Corporate profits remain well supported by global growth and cost discipline. Wage growth, in particular, remains subdued, even where full employment has been achieved. Investors are likely to reward companies with demonstrated revenue growth, for instance in quality styles and information technology. We remain cautious on Europe and emerging markets, despite more attractive valuations. Europe may yet deliver better earnings growth, but its inability to do so in a broad and consistent fashion thus far in the cycle suggests that investors will remain sceptical until the earnings recovery is plainly evident. A sustained reversal of US dollar strength is probably necessary to boost sentiment toward emerging markets.
We also remain short duration in global government bond markets, limiting fixed income exposures to shorter duration specialty credit (such as mortgage-backed securities, insurance-linked bonds and floating rate notes, all of which are typically lower volatility holdings). The Fed is likely to hike rates twice this year and three times in 2019, given the restoration in the US of full employment, continued above trend growth and the attainment of its mandated rate for core inflation. Notwithstanding ‘dovish tapering’ rhetoric from the ECB, its normalisation of policy is also likely to continue this year and next. Finally, some adjustment of the Bank of Japan’s yield curve target remains possible before year end.
Overall, therefore, we feel investors ought to be patient and ‘ride out’ current market conditions. Selective risk allocation to equities and short-duration credit with an emphasis on low correlation and capital preservation, accompanied by a flexible tactical asset allocation, remains our preferred multi-asset approach for the second half of 2018.