However, hesitancy and uncertainty can be good news for cautious optimists like us. We’re not suggesting now is the time to get rampantly bullish – it is too late for that. Rather than slugging at the punchbowl, we suggest enjoying a ‘glass half full’ while there’s still some time left at the party.
Looking back to the last quarter of 2018, markets were pricing in a rising probability of a global recession by this time in 2019. Now there’s renewed optimism across asset classes, with some predictions saying this cycle could have another leg in it. It’s as though the clock’s been wound back from a few minutes to midnight to perhaps 10 o’ clock. What’s the cause of this ‘about-turn’ optimism?
We think the reasons come down primarily to policymakers. Central banks have been rolling back from taking the punchbowl away. If policy was one of the things that took markets lower in the last quarter of 2018, the swing in policy rhetoric, and consequent action, was one of the main reasons why the market cheered coming into 2019. It goes to show how important the attitude, and actions, of the hosts are to the success of a good party.
Delving into the two dominant demand engines, the US and China, we can trace back to the time when the US Federal Reserve (the Fed) said there was going to be two or three interest rate rises in 2019. Now the central bank may lower rates, depending on how economic growth goes this year. In China, the risk of a hard landing is being diminished thanks in large part to considerable structural and fiscal improvements by the government. Why the policymakers have geared into action is clear – the macro picture has deteriorated, with worse-than-expected data supporting the notion that we may be on borrowed time.
Just how much borrowed time we have, and how successful policymakers’ tinkering has been, is still unclear. We’re now seeing one or two green shoots, notably in China itself, in much stronger credit data, recent improved Purchasing Managers’ indices and other leading indicators suggesting that the worst of the global slowdown is near.
But there’s a dichotomy here. On the one hand, everyone’s drinking from the punchbowl with optimistic indicators supporting a healthy economy such as the US jobs report in March, which consequently beat expectations with 196 000 jobs added. On the other hand, an inverted US yield curve has raised fears that, if history is a guide, a recession is highly likely in the next 12-18 months.
So the question remains, is this a durable recovery or more of a temporary upswing within a maturing business cycle? This is what markets and investors are wrestling with. The answer to which greatly determines whether you’re still at the party or cautiously heading for the exits. In our view, it’s getting late and no one wants to be the last person standing, but there is definitely room for a last dance. How this translates into portfolio positioning is all about timing.
If our dance had a name, perhaps ‘vigilant quick step’ would do – we’re aiming to be relatively cautious, while taking advantage of the opportunities in the market. For example, we think that the Fed has shifted away from just tightening “whatever happens” to a much greater focus on swings in data and in financial conditions. Moreover, we believe that bonds should revert to being more negatively correlated to equities, which they weren’t last year. This makes them a more useful diversifier within portfolios. They allow you to increase equity exposure by adding some duration as an offset in markets where yields are relatively attractive and where interest rates could be cut in the future, for instance US Treasuries.
Options continue to be very interesting because they remain attractively priced, implying that investors see little risk of uncertain outcomes in the future, which is what options basically insure you for. So you pay little for that insurance, and you can use them to participate in market upside if it happens, but avoid market downside. It seems to us that you could easily paint a picture where equities could be up 20% in a year or down 35-40% and so options are a perfect way of playing that uncertainty at relatively low cost.
Let’s not forget how late in the cycle it is. Historically, equity markets peak about six to nine months ahead of a recession. So if it is 18 months away, you need to be thinking about how you might begin to exit and the mix of assets that you hold to insulate the portfolio from volatility and the big unknowns.
Even if no recession is imminent, it is prudent to manage the portfolio to withstand a range of possible risk events that could transpire over the coming year. We’ve been here before. Uncertainty surged in the lead up to the Brexit referendum in June 2016. While no one could predict which way the vote would go, we were convinced that the outcome would have a significant market impact in either direction, and so we chose to temporarily scale down exposure until the result was known. To do so, we hedged out some of our equity exposure, reduced our sterling exposure and increased bond holdings, prior to the referendum. The net impact was that the portfolio remained flat over the referendum result, when equities fell 8%. Thereafter we unhedged the portfolio and participated in what turned out to be a surprisingly strong rally in risk assets after the initial uncertainty began to fade away.
Similarly, in 2018 we reduced the portfolio’s sensitivity to tighter monetary policy and reduced exposure in the ‘melt-up’ euphoria early in the year. We also responded to the rising recession risk as the year progressed, helping the portfolio to avoid much of the drawdown in markets over the period but especially during the last quarter of 2018.
Uncertainty remains high as we move through 2019. We continue to actively manage the risk within the portfolio by focusing on the best ideas at a security level to capture the opportunities that the market still presents. Given our risk and return objectives, the overall mix of exposures is well diversified by sensitivity to the economic cycle, so everything isn’t going up and down at the same time; exposure to known risks such as the uncertainty around Brexit is limited; and we actively manage the risk behaviour of the portfolio to changing market conditions.
The clock is ticking.
We aim to be prepared, coats on, keys in hand and dignity in check, when the time comes.