Four of the big talking points dominating headlines are trade wars, Brexit, rising interest rates and most recently, global recessionary risk.
Investors are grappling with this backdrop of trade tensions, political instability, rising interest rates, and a mature business cycle. Yet, perhaps of more importance, investors are now also questioning the durability of returns and recognising that markets won’t always go up. Under such a dynamic, the investment landscape is offering both opportunities and dangers.
Trade Wars
Investors have punished emerging markets in 2018, but we think the sell-off hasn't been justified by fundamentals. We still like emerging markets, both stocks and bonds, as we believe the downturn in sentiment towards this investment area has been driven largely by fear.
A key focal point has been the trade-war rhetoric, with emerging markets being put under significant pressure as capital outflows persisted. This is true both at an asset level and at a currency level, although the fundamental thesis and economic progress is largely unchanged.
Perhaps most prominently, we saw the execution of trade tariffs, which severely dented sentiment towards some of the emerging markets and supported the US dollar. Amid the concerns, we also saw further weakness in Europe as export-driven markets like Germany sold off.
Positioning: We believe a healthy allocation to emerging markets and Europe is warranted. Both regions offer reasonably attractive reward-for-risk, especially compared to the US market.
Brexit
UK investors are being forced to contemplate some incredibly difficult decisions. With Brexit a major fundamental risk to the economic outlook, nervousness is taking hold. The first thing to acknowledge is that the UK economy is not the UK equity market. Approximately 70% of the FTSE 100’s earnings come from overseas, and one must appreciate that the fundamentals of corporate Britain have been reasonably resilient.
Given the unprecedented nature of Brexit, many investors struggle to comprehend how to price it into asset values. The fund flows appear to show that managed fund and ETF investors are erring on the side of caution and investing elsewhere, which is no doubt influenced by the noise of daily politics.
Positioning: While the economic relationship with the UK’s largest trading partner will remain unclear for some time, we are pragmatically and patiently growing more positive on multinational UK equities. We are more cautious towards UK domestic stocks and don’t see much appeal in UK fixed income. We also like the pound sterling at current levels, although acknowledge that further downside risk is present.
Rising Interest Rates
For some time now, investors have had to grapple with the implications of increasing borrowing rates. This theme continued through 2018, as most central banks, excluding Japan, have made it clear that they are either unwinding, or planning to unwind, the monetary stimulus that has persisted for the best part of a decade.
This has muted returns from some fixed income markets, especially government bonds with longer duration, whilst inflation-protected bonds continue to be shaped by a rollercoaster of changing inflation expectations.
Corporate bonds have also had to deal with a modest rise in spreads as investors seek higher yields for taking on credit risk. We have reason to believe that bond yields will trend higher and revert towards more normal levels, but we can't predict the path or timing. But the larger issue may be a behavioural one, as it often is – it's easy to fear rising rates and rashly trade out of bonds.
This would be a mistake in our opinion, as we can't know the future, and higher-rated bonds continue to provide diversification to equity risk. The path to higher rates is anything but certain, and bonds can play an important role in most market environments, particularly if trouble lies ahead.
Positioning: As yields rise to more sustainable levels, we're gradually adding bond exposure across our portfolios. However, we've also taken steps to mitigate the potential losses caused by rising rates. This includes shorter-duration positioning and a preference for higher-quality issuance.
Global Recession Risk
From our fundamental work, it is clear that corporate profits have been trading at cyclical highs for some time, especially in the US market. At the same time, a range of economic indicators – from manufacturing surveys, car sales and house prices – suggest economic growth is moderating.
This combined with stiffer regulations and some high-profile corporate failures has led investors to question the lofty expectations of large swathes of the equity market. We're always careful of the "this time is different" argument, so we looked carefully at the factors that may explain higher profitability at US firms. We found some cause for profit margins to remain higher than normal, but over time we expect these margins to eventually retreat.
Positioning: We think US stocks are overpriced and believe selling overpriced assets is a good discipline. We maintain our cautious stance towards the US market, with the asset class now offering negligible expected returns after inflation, on our valuation analysis.
Summary
From a performance perspective, markets continue to experience mixed conditions that carry an undercurrent of nervousness. This is consistent by broad asset class – whether we are talking about equities, fixed income or currency – but also in rhetoric. Whether this offers opportunities in 2019 remains to be seen, but it does create an interesting landscape for us to add long-term value.
