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Multi Asset Perspectives: Post-peak trauma

20 November 2018

Earlier this month the asset allocation committee met amid the market volatility of Q4 2018 to consider the outlook through year-end. A brief summary follows.

Incomplete rotation

Following sharp sell offs in global equity markets, which commenced in October and are yet to abate in November, the asset allocation committee met in early November to consider the investment outlook through the end of the year.

Investors have opted to de-risk portfolios over the past six weeks, shedding equities and, in particular, the most heavily owned segments of the global equity market. Information technology and quality stocks, alongside major US indices, have led the way lower. Notably, some traditionally higher beta segments, including emerging equity markets, have outperformed. The implication is clear. Investors are de-risking by offloading positions they acquired earlier this year, namely the consensus longs in the market.

Also notable was the fact market volatility has been largely contained to global equities. Given the magnitude of drawdown in stock markets, corresponding moves in government bonds and currencies have been relatively small. In other words, investors have de-risked without correspondingly increasing holdings of either ‘safe haven’ or other assets. Cash is king. Investors know what they want less of, but are uncertain about where to reallocate.

All of this behaviour is consistent with the new paradigm in markets – post-peak. US growth peaked in Q2 of this year and is likely to slow going forward. Either capacity constraints will gradually apply the brake to growth or the Fed will ensure that outcome by raising rates until activity ebbs. After all, the Fed is witnessing a gradual rise in inflation, which in core terms is already at its target. The Fed cannot tolerate above-trend growth much longer.

Meanwhile, no other part of the world looks primed to replace the US as the global locomotive. If anything, fears of weaker activity in China have emerged, which have only been compounded by efforts to boost spending via credit easing. Europe reported another quarter of tepid growth in Q3. Even if special factors (ie seasonal declines in auto production) were to blame, few believe a year-end GDP bounce will persist into 2019. Japan and the remainder of the emerging complex are similarly uninspiring.

Post-peak is also about earnings. Despite another strong quarter of year-on-year earnings growth, the Q3 US reporting season failed to impress. Investors are more concerned about the outlook than the just concluded quarter. Cost pressures were cited by a growing number of firms during the earnings season. Margin compression is already underway – profit share in US GDP has fallen steadily over the past two years (Chart 1).

Chart 1: US profit share in GDP

Chart 1: US profit share in GDP

Source: Haver, BLS, NBER, GAM Investments.

Past performance is not an indicator of future performance and current or future trends.

 

Similarly, with the sole exception of Japan, which is quietly engineering a decade-long impressive improvement in profits as a share of national income (Chart 2), the earnings picture is hardly buoyant outside the US.

Chart 2: Japanese profit share in GDP

 Chart 2: Japanese profit share in GDP

Source: Haver, National Accounts, GAM Investments.

Past performance is not an indicator of future performance and current or future trends.

 

In short, we believe there is no substitute for US economic and profits leadership.

Post-peak has a final disturbing implication. Earlier this year, when US growth was robust and accelerating, investors could climb the proverbial ‘wall of worry’. Today the same issues, ranging from the risks of trade conflict escalation to political uncertainty, Fed tightening or asset price valuations, have become paramount concerns. When growth is past its peak, the ‘wall of worry’ becomes tougher to surmount.

Tactical asset allocation implications

So how should investors position for the final six weeks of 2018?

The asset allocation committee concluded that post-peak trauma is unlikely to give way to a strong traditional fourth quarter rally. For most of the past decade, investors have not bought assets merely because they were inexpensive, so more attractive values alone are unlikely to attract sufficient interest to lift markets. Instead, investors require a catalyst to re-engage. Sadly, that catalyst is missing. That is why gridlock in Washington – all but ensured following the US mid-term elections – is unlikely to buttress investors, as has often been the case in the past.

The base case, therefore, is that we believe market performance will remain uneven and more volatile. In our view, overall allocations to equities ought to be lower – a shift we have also initiated in some strategies. Minimum volatility and higher quality growers, companies with resilient margins, are preferred. Given inflation and monetary policy lag the growth cycle, we prefer to remain short duration, with a preference for specialty credit, such as non-agency mortgage-backed securities or insurance-linked debt. We also retain a preference for liquid alternatives, target return and alternative risk premiums as ways to bolster diversification in multi-asset portfolios.

We believe post-peak implies lower returns and falling Sharpe ratios. We are positioning accordingly.

 

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator of current or future trends.
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