2019 is likely to be a challenging year for financial markets. We are already in the tenth year of a bull market for most pro-cyclical asset classes. A bear market is probably just a matter of time. Valuations are no longer compelling and potential catalysts for a market drawdown are building. These include a variety of leading indicators which, if history is a guide, suggest a recession by late 2020 is becoming increasingly likely. In addition, monetary policy, which has supported asset prices for much of the last decade, is beginning to become less accommodative.
In particular, quantitative easing is gradually being pared back globally and the US Federal Reserve (Fed) has begun to shrink its balance sheet and raise interest rates. The strains this is causing are being transmitted primarily to the rest of the world, especially net debtor nations in the developing world, rather than tightening financial conditions materially in the US. Unfortunately, this absence of tightening alongside loose fiscal policy gives the Fed every reason to continue to tighten policy.
Other potential drivers of a more bearish market environment include:
The case for adopting a steadily more defensive posture in portfolios is, therefore, pretty clear. The problem is that the onset of the next bear market remains highly uncertain. If the global economic expansion still has a year or more to run, then equity markets could go on to new highs before they peak. In general, equity markets tend to rally until just before the onset of recession. A lot of smart people have been cautious throughout this bull market and have missed significant gains as a result.
There is a cost in being too early as well as being too late, but it is probably harder to time being early. We would feel more comfortable in calling a top if most investors were bullish, but they are not. So perhaps the market can continue to climb a wall of worry, as it has done over most of the last few years.
Fortunately, equity call options, which provide a way to participate if the rally continues, while protecting the downside, are still very cheap in a historical context. We think a sensible strategy is to sell equity futures to hedge some of our physical equity exposure and then buy out of the money calls to benefit if the bull market carries on.
We think it is too late in the cycle to own much exposure to corporate bonds, given rising uncertainty. We are also cautious about whether government bonds will provide a hedge if equity markets fall. At least, initially, we worry that bonds and equities might sell off together if tighter monetary policy is the main driver, at least until central banks are compelled to change course.
Figure 1: Credit vunerable to rising uncertainty
Forecasts are inherently limited and are not a reliable indicator of future results.
Source: Bloomberg, Investec Asset Management July 2018.
US President Trump’s policies and the resulting growth divergence with the rest of the world remain dollar supportive, which may keep the pressure on countries with weaker balance of payments positions, although some of these appear increasingly oversold. The Japanese yen stands out as being significantly cheap and offering naturally defensive behaviour if equities crack, thanks to Japan’s status as an international creditor.
Figure 2: Japanese yen deviation from fair value
Source: Bloomberg, 15.11.18.
There are selective value opportunities in many areas and a bottom-up security driven approach looks increasingly relevant at this stage of the market cycle. A focus on holdings with attractive valuations and yields supported by sustainable cashflows should help to underpin returns in a difficult market environment.
Jason Borbora: A defensive stance
As part of The Big Picture Podcast channel, Jason Borbora looks ahead to the next year, where he sees security selection looking evermore critical as the cycle nears its inevitable end.Listen to the podcast Subscribe to our podcast channel
Global economic growth diverged in 2018, with the US economy supported by a large dose of fiscal stimulus through tax-cuts and public spending hikes. In contrast, most of the rest of the world is seeing the opposite with developed markets (ex-US) and emerging markets coming under pressure as China reduced its stimulus and rising US interest rates squeezed liquidity.
As US fiscal stimulus wanes and interest rate increases bite, we expect a deceleration of the US growth trajectory. More specifically we have identified three primary drivers that broadly characterise the investing environment for our strategy:
Strong liquidity has fuelled the recovery since 2009, with low interest rates and aggressive central bank buying of government and corporate bonds. However, global liquidity is now reducing, driven by US interest rate hikes and the US Federal Reserve’s quantitative tightening (QT), which accelerated at the end of October with a monthly rate of US $50 billion a month. Contrast that with a positive monthly purchase rate of US $85 billion at the peak of the third round of quantitative easing. The US Federal Reserve will likely focus on broad financial conditions, which could well stay loose even as monetary policy tightens due to the build-up of capital through private market channels being redeployed into lending opportunities. This could push interest rates higher than the market currently expects.
The Federal Reserve is not the only central bank withdrawing liquidity with the European Central Bank and Bank of Japan also shrinking their balance sheets through the year. With low interest rates and extraordinary monetary measures acting as a source of support for markets for nearly ten years, the slow withdrawal of liquidity clearly creates risks given the market’s sensitivity to the cost of money (Figure 1).
Figure 1: US Federal Reserve balance sheet set to shrink.
Source: Bloomberg, as at 31.10.18.
Over 2018, the growth impetus was driven by the US, while other regions slowed more decisively. The tax cuts and spending that targeted US companies and consumers will likely only have a short-term impact. Growth may fade, with the potential impact of tariffs increasing uncertainty for business and pushing up costs.
Figure 2: Fiscal stimulus continues to support the US economy
Source: Bloomberg, as at 31.10.18
The significant divergence between the US and the rest of the world would seem to suggest a heavy exposure to US assets. However, we believe this divergence is well priced into many investments, potentially limiting any upside. In addition, the rally in US assets hasn’t been of particularly high quality. For instance, ten primarily technology stocks explain 50% of S&P returns year-to-date, highlighting the narrowness of this market and vulnerability to shocks.
The global political order is shifting, which has the potential to continue to unsettle markets. The rise of a populist and anti-EU party in Italy, along with the structural inadequacies of the euro zone, have resulted in meaningful divergence in the performance of the core versus periphery1. The core has benefited significantly from an undervalued currency. On the other hand, the periphery is saturated with debt, has a highly leveraged banking system, declining working age populations and stagnating productivity. We believe the odds are stacked against the euro zone growing out of its current troubles. While this will play out over a multi-year time horizon, the change in politics increases near-term instability.
An explicit focus on US national interest from the Trump administration has come through in the application of sanctions as a form of economic warfare and tariffs to force negotiation of existing trade treaties. History shows that protectionist policies can quickly become competitive, reinforcing and destructive. There are clear losers from rising protectionism, such as South Korea, as well as those which could benefit from a de-escalation of this rhetoric, like Canada.
Macro concerns are an enduring feature of markets and over the past 10 years asset markets have generally surmounted them. At this time, the valuation of many assets and high company margins raises the risks from slower growth, tighter liquidity and less predictable politics. These concerns suggest a cautious positioning, with diversity designed to help offset these risks alongside target Growth-orientated positions. The potential shift in the liquidity environment could expose the weaker links in global financial markets.
We hold positions that continue to offer meaningful long-term return potential and predominantly take this risk through equity markets rather than debt or currency. The core of our equity exposure is invested in a ‘total-return’ approach. This approach seeks to invest in high-returning companies that are underappreciated by the market for their ability to reinvest their profits and compound returns sustainably due to their durable competitive advantages that compound with time. We continue to find companies that satisfy these criteria.
However, years of extraordinary liquidity provision and low interest rates have compressed the risk premia offered by the full range of asset classes, which inflated valuations. This has particularly been the case for income-generating asset classes. Likewise, the sharp increases in capital flowing to private debt markets indicate the tail end of this trend.
Growth divergence and shifting interest rate policy over the past year has however introduced some valuation dispersion within asset classes, taking Asian equities relative to the US as one example. We expect the macro risks and regime shifts over the next year to generate attractive opportunities and greater variability in risk premia. Achieving our return objectives requires us to increase portfolio risk at times when there are more plentiful opportunities. We will take advantage of these as they arise.
1Germany is at the centre of the ‘core’ group of countries in the euro zone, while Greece, Italy, Portugal and Spain are conventionally seen as forming the ‘periphery’ (http://www.lse.ac.uk/european-institute/Assets/Documents/ LEQS-Discussion-Papers/LEQSPaper104.pdf)
As we progress further into an era of reduced central bank support and tightening liquidity, we believe that while fundamentals and valuation will play a role, market price behaviour will remain the key driver in 2019. We still see good opportunities for investment in some credit markets, but increased bouts of volatility are likely to become the norm. The stage is set in the year ahead for the nimble, and well positioned investor, to take advantage of the move from quantitative easing to quantitative tightening (QE to QT). Below we use our ‘Compelling Forces™’ framework, segmenting credit market drivers into Fundamentals, Valuation and Market Price Behaviour, to examine these themes in more detail.
Going into 2019, the general fundamental backdrop remains sound. The auto sector aside, the robust growth experienced through much of 2018 is slowing rather than turning negative. As such, we think the threat of a very near-term recession is small. This macroeconomic strength has largely fed through to corporate earnings, particularly in the US. This has also translated into a continuing moderation in corporate leverage levels, which currently stand at elevated, but not overly aggressive levels. However, this varies somewhat by market.
It is notable, however, that certain subsets of the economy have recently shown signs of weakness. We have started to see a moderation of momentum in several of the traditionally more cyclical sectors, such as autos, industrials and homebuilders.
As individual issuers within these sectors have reported weaker financial performance, we have typically seen aggressive repricing of their equity or credit spreads, as illustrated below by the equity and bond prices of global chemicals manufacturer Trinseo (Figure 1). This asymmetric price reaction on any earnings miss clearly illustrates the increased value of selectivity.
Figure 1: Trinseo: equity and bond prices compared
Source: Bloomberg, 30.09.18.
However, this localised stress has yet to filter through into broader measures of market health. As such, default rates have continued to moderate, alongside continued positive ratings drift (more upgrades than downgrades) momentum.
Figure 2: Default rates are moderating
Source: Moodys. As at 31.10.18.
In a year of more divergent performance across the credit market subsets, the relative attractiveness of different credit markets is currently quite variable. Certain subsets, such as US high yield, are trading close to post-crisis lows. Other segments, such as European high yield, have repriced wider since the start of the year. Figure 3 provides a snapshot of the large developed market bond markets, illustrating the variability of these valuations in the context of each asset classes' history.
Figure 3: Current corporate bond spreads, percentile against history
Source: Deutsche Bank, FactSet (ICE BAML). 30.09.18.
The reasons for this valuation divergence differ from case to case. They can be idiosyncratic in nature (e.g. Italian political risk) or down to particularly supportive market technical factors (e.g. US high yield). We believe it is too difficult to generalise in terms of the attractiveness of valuations given the multitude of factors which need to be considered when assessing each market subset.
While we still see potentially attractive risk-adjusted returns across various subsets of the market, we think the year ahead is less about reaching for returns and more about preservation of capital. In this vein, dynamism and selectivity are going to be key to avoiding the more susceptible areas of the credit market.
In our view, market price behaviour will continue to be the main driver of markets in 2019. The ‘safe havens’ may not necessarily be where investors expect them, given the impact of extreme monetary policy over the last decade.
Credit markets, along with most financial markets, have benefited significantly in recent years from a wave of central bank liquidity. Easy money has rippled through all credit market subsets, providing a strong tailwind for tighter valuations, supported by improving underlying fundamentals. However, the recent shift from QE to QT, in our mind, is likely to have a material impact on market momentum. The retrenchment of tourist investors (tactical allocators), who don’t consider credit a mainstay of their investing, leaves some areas of the market susceptible.
As such, understanding the behavioural dynamics of individual market subsets is a key theme for us and further illustrates the need for selectivity. We believe this dynamic, along with issuance levels and fund flows, will likely have a meaningful impact on market direction in the year ahead.
We believe there are still attractive risk-adjusted returns on offer among the different subsets of the credit market. However, we believe selectivity is going to be key in the year ahead, not only in terms of individual credit selection, but also in selection of subsets of the credit market. We also believe dynamism in both these regards is going to be critical in 2019.
This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein.
All rights reserved. Issued by Investec Asset Management, issued November 2018.