What are the key risks that investors face in 2019?
We see risks coming mainly from three distinct sources:
- the US economy could overheat
- trade tensions between China and the US could escalate
- Italian political turmoil could trigger systemic eurozone risks.
The US economy runs the risk of overheating because spare capacity is now low and inflation is near the Fed’s 2% target (see exhibit 2). The Fed is in the middle of raising policy rates and reducing its balance sheet to prevent the economy from running too hot. But this is a tricky balancing act because policy normalisation (or quantitative tightening) should push ‘risk-free rates’ higher, potentially destabilising the valuations of riskier assets. Fiscal stimulus is also complicating matters as the Fed now has another source of demand pressure to contain.
Exhibit 2: US inflation has (finally) moved closer to the US Federal Reserve’s target rate; 2008-2018 (in %)
We believe that the China-US tensions are rooted in a struggle for global hegemony and not just in trade imbalances. The trade tensions are a reflection of that struggle and are therefore likely to be with us for some time. Should they lead to further market stress and pressure on trade volumes, it is global growth and in particular emerging market growth that could suffer.
In Europe, the dispute between Italy and the European authorities is also likely to endure. The main risk here is that Italian sovereign debt suffers to the point where investor concerns about debt sustainability or about anti-euro political rhetoric revive eurozone break-up risk. This would be damaging for the region’s growth prospects and the valuations of European risky assets.
One potential complication is that these three risks could easily compound if they escalate. For example, higher US interest rates could lead to contagion in Europe. Or trade tensions with China would have knock-on effects on other trading partners, including the eurozone. Finally, weaker eurozone growth could weigh on global economic sentiment, negatively impacting the outlook for the US and China.
What are your main asset allocation recommendations going into 2019?
Given our baseline macroeconomic scenario of robust but weakening global growth, gradually rising inflation pressures and monetary policy normalisation, we are neutral on equities and underweight fixed income. But we also recognise that we have to be more tactical and reactive around this basic mantra because of the risks around our central case.
For example, following the October correction we went long developed market equities (MSCI World). We prefer to avoid a high concentration of risk in regions that are directly exposed to the risks around our central case.
In fixed-income markets, our basic proposition is that as the US business cycle matures and the Fed continues to withdraw policy accommodation, interest rates will rise further. This is potentially a sea change for macro investors as under this scenario, US Treasury bonds are likely to be less effective in offering protection for risky portfolios.
We prefer to express our underweight fixed-income exposure in eurozone government bonds as we see scope for a greater upward correction in yields than in the US.
We would also underweight high-yield credit, especially in the US. Relative to historical levels, spreads (a measure of credit risk premia), are tight and as an asset class, credit is vulnerable to quantitative tightening.
As we explained above, we face three sets of risk that are unlikely to be resolved quickly: overheating of the US economy, US-China trade tensions and European political risk. That means that we will need to trade around those themes, especially when we consider that markets are not pricing them correctly. An example is our short EUR/USD exposure, which would work if Italian risks become more systemic or the US Fed tightens policy faster than anticipated to contain inflation.
What other factors do you think investors should consider beyond the fundamental/macro-economic outlook?
The bull market in US equities has been one of the longest in recent history and it has been driven by extraordinarily accommodative monetary policy and a sustained economic recovery (see exhibit 3). As a result, distortions such as historically low asset price volatility have been building in financial markets over the years. These imbalances are at risk of unwinding as markets face the crosscurrents of a strong, but ageing US business cycle and policy normalisation.
Exhibit 3: US bull market has kept on running and running; 1990-2018 (S&P 500 index, weekly data)
In this environment, markets are likely to be more sensitive to factors that affect market dynamics such as sentiment, volatility, liquidity and positioning. We use these indicators along with our in-house dynamic technical analysis to assess the prospects for market dislocations. Note that these dislocations may or may not reflect news or data on fundamentals.
It is these factors which, for example, signalled to us to reduce risk generally in September and to underweight US IT stocks relative to the overall US equity market. Sentiment indicators looked stretched at the time, volatility was historically low, and US companies were in a news blackout period that meant any share buybacks would be less supportive of prices.