Strategic Relative Value - Q4 2018
A quarterly look at how macro events are driving relative value around the globe.
"The investment climate is becoming more challenging as previous easy monetary conditions are being reversed. Risk/return expectations need to be reevaluated, but investment opportunities still exist around the world."
- In 2019, softer global growth—driven mainly by a weaker US economy—and tightening financial conditions will weigh on risk assets. Yet, weaker growth doesn’t mean negative growth. With a recession still unlikely, I continue to prefer equities to fixed income, but investors should prepare for lower returns and diversify globally.
- The last 10 years of strong asset returns have not been driven by strong economic growth, but by extraordinarily easy monetary conditions. But now, monetary policy is well on its way to becoming restrictive. The Federal Reserve (Fed) is likely to raise rates again in December, followed by at least one more increase in 2019.
- The European Central Bank (ECB) should end asset purchases in January and start rate hikes over the summer. The Bank of Japan’s (BOJ) tepid inflation outlook means it’s likely to remain extremely accommodative. Soon, though, the combined balance sheets of the Fed, ECB, and BOJ will be shrinking—a clear negative pressure for risk assets.
- In the United States, the effects of the tax cuts are waning, tighter financial conditions are starting to bite, and the negative impact from the trade conflict with China is starting to show in companies’ earnings guidance. Given these risks, I prefer international equities to US equities.
- The market narrative around emerging markets is due for an upgrade. Valuations have become more attractive and should soon offset the deterioration in fundamentals. However, a positive catalyst—perhaps a fading in US and China trade tensions, but more likely a weaker US dollar—may be required before emerging markets can outperform.
- Elevated market stress, growing macro headwinds, and the return of cash as an alternative asset class are weighing heavily on the credit outlook. With spreads likely to drift wider in both the United States and Europe, I prefer to be underweight credit. Within credit, I prefer to go up in quality, so I prefer investment grade over high yield.
- Without a recession, a deep and sustained bear market would be unusual—either an extended period of shallow negative returns or a short period of sharper negative returns is more likely. At the same time, the uncertain macro environment means frequent bouts of market stress, increasing the importance of active management in 2019.
- The outlook rests heavily on the path for interest rates. If the Fed pauses before it reaches the neutral rate, US equities could receive a boost, while a rapid narrowing in credit spreads could also take place.
Relative value in...
US equities have suffered two corrections this year, both partially triggered by sharp repricing of Fed expectations and rising bond yields. Additional monetary tightening is likely, while the strong Q3 earnings season may have been the peak. Expect further equity market weakness. (see Exhibit 1)
- International equities over US equities: Rising rates; the delayed negative impact of the stronger dollar; fading impact of fiscal stimulus; decreasing profit margins; and concerns about the impact of the trade war on US multinationals suggest that US equities may underperform world benchmarks.
- Japanese equities over European equities: Valuations are attractive, the BOJ is very accommodative, corporate profits continue to rise, while Japanese GDP growth is due for a sharp rebound as the negative effects of natural disasters fade. A stronger yen may be a headwind in 2019, but earnings have become less sensitive to currency moves. Europe could be a promising alternative if Italian political risk is resolved.
- Cautiously constructive on emerging markets: In Latin America, recent sharp moves have left valuations expensive. By contrast, the significant improvement in emerging Asia valuations and a likely pick-up in the Chinese economy in 2019 as the various monetary and fiscal stimulus measure kick in suggest that soon there will be a good entry point for investors to build up a long-term strategic position in Asia.
- The catalyst for increasing emerging market exposure may be a weaker US dollar: The upward trend in the dollar has potentially just about run its course as the relative performance of the US economy deteriorates, and as investor positioning and sentiment unwind.
- Defensives over cyclicals: The macro case for a rotation from cyclicals to defensives (such as utilities, consumer staples, and healthcare) is solid. However, stay cautious, given that valuations for cyclicals are now looking attractive relative to defensives. The challenging environment also suggests that value stocks may outperform growth stocks.
- Challenging times ahead for technology: While the strong outlook for buybacks could temporarily sustain tech outperformance, it faces regulatory and taxation pressures, while weak Chinese growth is weighing on consumer demand of luxury tech goods. In addition, recently introduced US controls of tech-related exports to various Chinese companies suggest that the tech sector is very vulnerable to the ongoing US and China trade war.
- Neutral energy and underweight financials: OPEC is likely to make production cuts, relieving some downward pressure on oil prices and providing support to the energy sector. Financials may continue to struggle as dollar hedging costs rise further and economic growth moderates. Within financials, I prefer insurance over banks. European banks will be under significant pressure from Italian political risk.
- Tightening financial conditions and elevated leverage mean that companies with strong balance sheets, high profit margins, and stable revenue should outperform. In this challenging macro environment, active investing is preferable over passive investing.
Relative value in...
While a recession in 2019 is unlikely, a softening macro backdrop and record-high corporate debt mean that credit has become highly vulnerable to financial stress and downgrades. Also, the return of cash as an investable asset class greatly limits the scope for spreads to narrow. (see Exhibit 2)
- Government bonds could deliver negative returns: Investor sentiment has periodic romancing of a “dovish Fed” narrative. Unfortunately, this leaves markets vulnerable to a repricing of interest rate expectations. With US unemployment so low and wage growth starting to pick up, the Fed could tighten policy by more than the market is expecting, putting upward pressure on US Treasury yields.
- U.S. Treasurys over German bunds: The spread between US Treasury and German bund yields is at record highs. Rising German wage inflation, coupled with the end of ECB asset purchases should lead to US-German spread narrowing.
- US credit to European credit: Although US credit is facing a slower growth environment, European credit also has its challenges. Italian political risk is set to linger into mid-2019, the macro environment is lackluster, and the ECB is ending its corporate bond asset purchase program.
- Dollar hedging costs to remain an issue for US credit: Additional Fed hikes will put further upward pressure on hedging costs, while the almost-flat yield curve has eroded any carry pick-up. Foreign demand for US credit is likely to moderate further, benefitting European and Asian credit.
- Investment grade over high yield: Weaker growth, continued monetary policy tightening, pressures on margins, and still-expensive valuations could weigh particularly on high yield. In addition, the steep drop in oil prices has raised concerns about high yield given the strong concentration of energy companies in that universe.
- Focus on moving up in quality: There are increasing concerns over the risk of a possible wave of BBB-rated issuers being downgraded to high yield. A theme of “up in quality” should characterize credit markets in 2019. Corporates with strong balance sheets and ample financial cushions are likely to outperform.
- US banks over European banks: Italian political turmoil continues to weigh on European banks, although admittedly, contagion has been limited so far. In addition, European banks’ profitability continues to deteriorate.
- Emerging market debt over developed market debt: The bear market in emerging markets has left emerging market assets more attractively priced than their developed market counterparts. A convergence in global growth (with the US economy slowing and emerging markets eventually strengthening) should lead to a rebalancing in global capital flows and a strengthening in emerging market currencies, supporting emerging market local rates.
- Emerging market credit over US high yield: Despite recent widening, high yield credit valuations are less attractive than emerging market credit valuations. Of course, tightening global liquidity and number of macro headwinds implies challenging environment ahead for both high yield and emerging markets.