What our House View means for asset allocation and portfolio construction.
4 minute read
Taste of a higher volatility regime
- Slower growth and higher rates translate into lower expected returns for risk assets
- Continued Fed hikes increases the attractiveness of cash and continue to lay bare vulnerabilities
As central banks globally move toward policy normalisation, markets increasingly focus on the idiosyncratic drivers for asset classes, putting growth fundamentals and the political outlook ever more in the spotlight. Yet even allowing for this, 2018 has been an eventful year with politics playing a surprisingly significant role for market sentiment.
Politics playing a surprisingly significant role for market sentiment
The year started off on a positive footing as US tax cuts improved the US growth outlook, leading to a rally in equity markets. At the same time, however, it also increased expectations of further tightening by the Fed. The subsequent repricing of the Fed’s policy path concerned equity market participants and as volatility increased, a technical break in short volatility funds caused a spike in the VIX and a feedback loop which led to a further round of equity market sell off.
Throughout the year, European growth surprised to the downside and China’s deleveraging, as well as tightening financial conditions, slowed growth and dented the market outlook in EM. As relative growth divergence to the US increased, the weaker USD trend seen throughout 2017 was finally turned on its head in the first quarter of 2018.
The subsequent USD rally has revealed fragilities in EM and increased market focus on fiscal policy and debt funding. This focus led to extreme stress in Argentina and Turkey and a risk off move in other high yielding EM economics like Indonesia, India and South Africa.
Volatility to continue to move higher, particularly in rates
Economic surprises and political uncertainty have subsequently translated into higher volatility across asset classes (Figure 1). In 2019, we expect volatility to continue to rise, particularly in rates markets, as monetary policy in Europe and Japan follows the Fed and starts to normalise. The rise in equity volatility has been more prominent as liquidity shortages have exacerbated market moves.
Figure 1. Market volatility moving higher
Asset class volatility moving higher, particularly in equities.
Whilst higher levels of volatility should provide opportunities for macro investors, they also have implications for expected asset class returns.
We reduce our expectations for equity returns given lower earnings growth and a cap on valuations going forward
In combination with the continuation of a rising yield environment and downside risks around our central outlook that are likely to persist, rising volatility implies that Price-Earnings Ratios are unlikely to rise significantly from here.
Combining this with our expectation of slightly lower global growth in 2019 than over the last twelve months, we see a translation into somewhat lower revenue expectations across the major equity markets. In addition, rising labour and input costs won’t allow for a significant expansion of profit margins outside of those areas where companies are able to increase productivity and exercise pricing power. Consequently, we expect global earnings growth to take a step down from the strong pace seen during 2018. Taken together, lower earnings growth and a cap on valuations leads us – on balance – to reduce our expectations for equity returns.
But continue to expect positive equity returns and therefore we remain moderately allocated to equities
Arguably, equity and to some extent credit markets have priced the prospective deceleration in economic and earnings growth (Figure 2 and Figure 3). What’s more, above potential economic growth – which we expect throughout the course of 2019 across all major regions – bodes in and of itself well for equity returns.
Figure 2. Equity markets largely priced prospective deceleration
Regional PE Premium / Discount vs. own history.
Figure 3. Equity markets price further moderation in growth
Recent draw-down in global equities suggests markets have priced the prospective deceleration in economic and earnings growth.
Likewise, the Fed accelerating to above neutral rates (as indicated by the shaded areas in Figure 4) has in the past not caused any major and lasting drawdowns in US equities – and as per our expectation “neutral” will only be reached by the end of 2019.
Figure 4. Tight monetary policy does not equal draw-downs
Above neutral rates (shaded areas) has in the past not caused major and lasting draw-downs in US equities.
The tug of war between slowing economic dynamics, the balance of risks on the fundamentals being to the downside and trade tensions staying with us on the one side and continued above potential economic growth in what has historically been a favourable part of the cycle for equity markets leads us to remain only moderately allocated to equities.
One of the main drivers of asset price divergence last year has been the differences between US and Rest-of-World economic growth, whereby US growth accelerated, and Europe, Japan, and emerging market growth cooled. Strength in the US dollar and US equity outperformance has been the result. A key question for 2019 is therefore how relative growth develops.
We see the delta on growth across regions to be close to zero thus don’t expect major convergence. In terms of asset allocation, this means we remain slightly long the US dollar and maintain exposure to North American equities instead of distinctively shifting out of US assets. This is also the region where we see the strongest earnings growth dynamics currently (Figure 5).
Figure 5. Strong earnings growth in US
Relative growth reveals itself in the strongest earnings growth dynamics in the US.
We remain short duration as we believe markets are underestimating the pace of monetary policy normalisation
We are of the view that central banks will continue to focus on building domestic price pressures and, in the absence of large external shocks, will continue to normalise policy. Contrasting this view and comparing market pricing against our envisioned monetary policy tightening path lays the groundwork for our short duration positions. Only in the event of a severe escalation of trade wars do we envision the Fed pausing its rate hiking cycle, thereby offsetting some of the pressure on risky asset classes that will likely have emerged by then.
Both central banks and investors will need to watch events closely to determine what is noise and what is significant enough to feed through to the growth outlook.
As developed market interest rates rise, the risk-return characteristics of cash improve (Figure 6) which will in turn continue to put upward pressure on assets where market participants require a larger risk premium. Past years’ strong US dollar and rising rate environment has forced many central banks in emerging markets to hike to protect their currencies and limit the pass through of cuurency depreciation to domestic inflation. More attractive yields might have been the result but the feedback loop of higher rates into emerging economies will need to be taken into consideration when allocating to emerging market assets.
Figure 6. Cash becoming increasingly attractive
US yields relative to volatility shows short dated cash yields increasingly attractive.
In light of a substantial drop in broad equity market valuations against a global growth outlook that has historically been consistent with positive equity returns, we cautiously added to our overall equity allocation. That said, the increase has been only moderate.
Our risk allocation between equities and short duration is now more balanced
Within equities, the main change is a downgrade to European equities. This reflects a difference from previous House View cycles, where we had been rather cyclically exposed and most dominantly so via European equities. We changed our preference for European stocks in light of continuously disappointing economic data, weak current earnings dynamics and analysts’ overly optimistic earnings expectations for 2019. Furthermore, valuations have not adjusted enough when compared to other regions. Valuations in EM and the UK, on the other hand, have gotten substantially more attractive, hence our slight upgrade to both regions. What keeps us from running a larger overweight to EM is the fundamental, longer-term backdrop being one of rising rates, slowing growth dynamics and the potential for a trade war escalation between the US and China. If realized, all of these are expected to weigh especially on this asset class and offset some of the valuation argument.
Our preference for taking on risk among short duration and equities is now more balanced. Within government bonds, we are now less underweight in the US, given the latest step up in long dated yields. Whilst real rates in the UK offer a particularly poor return, we acknowledge that the imminent breakup terms between the UK and the EU pose a risk to that position. Canada returns to a neutral allocation.
Generally tight credit spreads at a time when monetary policy becomes more restrictive and growth slows, lead us to continue to run an underweight allocation to the asset class. Recent widening in credit spreads lead us to a less negative outlook. We continue to prefer European to US HY based on lower leverage and less sensitivity to lower oil prices.
We keep our underweight preference for commodity currencies, which have lately been caught in the dynamics of a slowing Chinese economy and a sharp decline in oil prices. EM FX moves to neutral given our upgrade to EM equities.