Investment Outlook

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January 24, 2019

Investment Outlook

Tom Elliott

Market sentiment: refreshingly robust. Investors are enjoying a recent succession of statements from Jay Powell and heads of regional Federal Reserve banks, stating that the U.S economy is robust while reassuring investors that they are sensitive to evidence that demand growth is slowing compared to last year and that the rate hikes pencilled into their ‘dot chart’ of December are not set in stone. This somewhat confused message is, though, having the desired effect. U.S corporate debt (which many consider to be a key sentiment indicator at the moment) is on course for the strongest month in five years. In USD terms the MSCI World index is up 5.2% (+2.6% in GBP) and the MSCI Emerging Markets index is up 9.1% as of 23rd January, (+ 2.2% in GBP), with gains evenly spread across most markets.  

While growth is slowing in the U.S, China, and Europe, much of this may now be priced into risk assets. All major stock markets are trading at, or below, 25-year average P/E multiples (according to research by JP Morgan). U.S Treasury long bond yields appear contained, the 10yr stable at 2.7%, well below the October peak of 3.3%. 

Brexit and the markets: The MSCI U.K has underperformed in local currency terms, up only 1.8% since the new year, as sterling as rallied on hopes that a ‘no deal’ Brexit will be avoided. A strong pound is bad for the sterling-denominated shares of the country’s largest companies, which tend to be large foreign currency earners. Small caps, in contrast, have rallied as the risk of a chaotic no deal fade with the MSCI U.K small cap index up 6.6% in sterling terms. 

Sterling is widely considered to be undervalued, particularly given that Prime Minister Theresa May is under immense pressure to explicitly rule out a no deal should her own Brexit deal be defeated when it is put to the House of Commons for a second time. Since no deal is the default position, if the Commons cannot agree on any Brexit option by 29th March, ruling it out would mean the government seeking an extension to Article 50 from the E.U. This would allow other options (such as joining EFTA, a customs union, a Canada free-trade agreement or a second referendum) to be considered by the government, and by Parliament which is increasingly muscling in on the process to the annoyance of Brexiters. Most economists believe all other options are preferable to a no deal. 

Liquidity squeeze. The combined effect of the Fed’s ‘run off’ of $50bn a month from its balance sheet, and the U.S Treasury running a near-trillion-dollar fiscal deficit this year, is to increase the supply of Treasuries that the market has to absorb. Given that the ECB has stopped its own quantitative easing program, and that the Bank of Japan appears to wind down its version of Q.E, this may well lead to higher Treasury yields and a ‘crowding out’ of private sector savings as they get swallowed up by the rapidly expanding Treasury market. Higher bond yields might, therefore, occur irrespective of any slowdown in U.S economic growth, and even if the Fed does delay its pencilled-in 2019 interest rate hikes. 

U.S subprime corporate bonds. As risk-free rates on Treasuries rise, will investors still support low quality corporate issuers? A substantial amount of new issues at the BBB grade in recent years has led to fears that, should there be an economic slowdown and/or financial crisis, many of these would be downgraded to subprime and overwhelm the subprime market. The current market value of the BBB issues is $2.7 trillion, nearly twice the entire size of the sub-prime market. A large increase in supply of subprime, during a period of market stress, may lead to panic selling by investors. All eyes are on G.E, a fallen angel if ever there was, and whose debt is now only just investment grade and is equivalent to 10% of the of the entire subprime market. 

A related problem is potential illiquidity in the corporate bond market as a whole, as proprietary traders and other market participants who used to ensure market liquidity have been forced by regulators to limit their exposure.

Other worries. Meanwhile, other worries continue to lurk in the shadows. These include fear of a U.S/ China trade war, a eurozone recession and/or financial crisis, the unknowable impact of Brexit on the U.K and European economies, and slower growth in the U.S and China. Market volatility looks set to persist in an environment of less dollar liquidity and the crowding out by the U.S Treasury, with quality defensive assets outperforming. The VIX index of implied volatility on the S&P500 is down from a high of 36 on Christmas Eve, to 19 today -still high by the standards of recent years.

A multi-asset portfolio for the long term. We favour a long-term run approach to investing, whereby investors choose a suitable combination of global equities and bonds (depending on their risk profile and investment horizon), and leave the portfolio unchanged. Regular re-balancing ensures winners are sold and losers are bought – which financial history, and common sense, supports. The chart below shows a typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor. Note that the chart shows neutral weightings for the long-term investor, it does not incorporate any near-term weighting suggestions made in previous paragraphs.

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