Q1-2019 Quarterly perspectives
Tavistock Wealth - Investment Team Outlook
Welcome to the Q1-2019 ‘Quarterly Perspectives’ publication
Previous Quarter Review
2018 was a roller-coaster year for bond, equity, commodity and currency markets. For many, it was a timely reminder that after years of nothing-but-positive returns, markets can go down as well as up. The fourth quarter proved particularly difficult and the month of December will go into the history books as one of the most volatile on record. However, despite the market turmoil, the portfolios performed in line with our high expectations and relative to their respective benchmarks. This performance largely stems from our decision to de-risk the portfolios. This quarter we increased exposure to European and Japanese government bonds, minimum volatility trading strategies and commodity equities, via an ETF that tracks the performance of gold producers. All these positions contributed positively to relative performance versus the benchmark.
Key Themes
Global growth has returned to the long-term trendline, although we expect this to moderate slightly as we near the end of the economic cycle. One of the big questions for 2019 is whether the rest of the world (ROW) can catch up with the pace of growth in the US and China. We believe there will be convergence. As a result, we like emerging market equities, particularly in Asia, given market-friendly reforms and attractive valuations. Another key theme is the future trajectory of US monetary policy. The Federal Reserve forecasts two rate hikes this year, but the bond market is taking a slightly more contrarian view. We believe it is unwise to “fight the Fed” and maintain our underweight allocation to developed market government bonds. Finally, financial markets will remain volatile in 2019 and as a result we increased our cash allocations and maintain our preference for diversified holdings in global equities and commodities.
Chart of the Quarter
Historically, the US 10-year Treasury yield and Fed funds rate have peaked at similar levels. As shown in the chart, we think this economic cycle has further to run and maintain our preference for risk assets.
Fixed Income
Softer economic data, geo-political frictions and market volatility have curbed the Fed and investor’s hawkish outlook. Previous forecasts for 2019 had predicted up to four interest rate increases throughout the year, whereas Fed fund futures currently imply a higher likelihood of a rate cut than a hike by year-end. Our view is that the Fed is likely to continue hiking, albeit at a slower pace than before, and as such we remain underweight government bonds and duration.
US corporate debt issuance in the BBB-rated sector has grown to over $3 trillion and now accounts for nearly half of the investment grade sector. We forecast that tighter financial conditions, via a combination of rising rates and quantitative tightening, will put upward pressure on refinancing costs. This will result in wider credit spreads and an increased risk of rating downgrades. Consequently, we are cautiously positioned at the short-end of the credit curve in the investment grade and high yield sectors.
Within emerging markets, we prefer hard-currency to local-currency debt given its historically elevated spread over US Treasuries and lower exposure to emerging market currency volatility.
Tighter financial conditions have historically influenced corporate credit spreads, particularly in the high yield sector. We remain positioned at the front end of the curve.
Equities
We continue to like global equities, particularly following the Q4 correction, which has brought valuations back to attractive levels. We prefer Smart Beta trading strategies via a combination of single factor and regional multifactor ETFs. Within our core allocation, we prefer the minimum volatility and quality factors. Minimum volatility tends to outperform during periods of heightened volatility, which is one of our key themes for 2019. Likewise the quality factor favours companies with stable and high-quality earnings that tend to outperform during periods of positive but slowing economic growth.
On a regional basis, we have upgraded our outlook for US equities where market expectations for earnings growth remain above the long-term average. Our favourite region is EM Asia, supported by the implementation of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, attractive valuations, structural reform and additional Chinese policy stimulus. We remain underweight European equities and neutral Japan and the UK where Brexit uncertainty continues to trump attractive valuations.
Within our satellite allocation, which we use to implement a small number of high conviction trading ideas, we are overweight commodity equities.
Our decision to upgrade US equities is in line with a selection of S&P 500 forecasts from the major global investment banks.
Commodities
Despite a positive start to the year, commodities posted a loss in the final quarter of 2018 and were down for the year. Worries over global growth and the bearish sentiment surrounding US-China trade tensions weighed on the asset class, despite some uplift from sanctions in the oil and metals markets.
We believe commodity markets remain an attractive asset class for investment in 2019. Concerns over the strength of the global economy are overdone and we like the diversification benefits commodities afford given a lack of correlation to traditional equity and fixed income markets. The sell-off last year provided an extremely attractive entry point for oil and gold specifically. As such, we initiated two new positions in commodity equities via ETFs that track the performance of companies in these sectors. Gold has bounced off its summer lows and we expect strong seasonal support going forward. We also like oil following OPEC supply cuts, which should bolster prices going forward.
This quarter we increased exposure to commodity equities via an ETF that tracks the performance of gold producers. Gold has bounced off its summer lows and we expect strong seasonal support going forward linked to demand from Asia.
There is considerable uncertainty surrounding sterling’s prospects this year. This chart provides a selection of forecasts from some of the major global investment banks.
Foreign Exchange
We retain a negative outlook on the US dollar following last year’s rally, which left the currency overvalued and detached from fundamentals. We expect US economic growth will moderate slightly this year relative to the ROW, driven by an improvement in US-China relations. As such, interest rate differentials will likely narrow and the US “twin deficit”, which refers to both fiscal and current account deficits, should also put downward pressure on the dollar. The Japanese yen will be the main beneficiary of a weaker dollar and heightened volatility, owing to its role as a safe-haven currency. As such, we have upgraded the currency one notch to neutral.
Sterling remains volatile and highly sensitive to the ebb and flow of Brexit negotiations. Parliament’s historic rejection of Theresa May’s Brexit deal and subsequent vote of confidence in her government further underlines the uncertain outlook as we rapidly approach the 29th March deadline. In our view, a deal remains more likely than a no-deal scenario and we see more upside than downside risk over the coming months. The currency remains very undervalued and eliminating the uncertainty associated with Brexit will likely lead to significant appreciation.
Final Thoughts
The financial press is obsessed with the need to forecast a recession in the US and a slowdown in China, but the numbers simply do not add up. The unemployment rate in the US is at a 49-year low and Trump’s corporate tax cuts are not going away anytime soon. China is slowing but is still expanding at a pace consistent with its early stage evolution into a market economy. Trade tariffs between the two countries is a non-issue, given that they account for less than 1% of global trade and a revised agreement is likely to be reached within months.
The International Monetary Fund forecasts global growth in the region of 3.5% to 4.0% in 2019, supported by the world’s two largest economies in the US (2.5%) and China (6.2%). Inflation remains benign and central banks have begun the long process of quantitative tightening, which will gradually lift long-term interest rates. Volatility is returning to the pre-2008 historical averages, but this continues to be a positive environment for equities and commodities despite being in the later stages of the economic cycle.
The global economy has grown at a healthy 3.7% for the last two years. We think the current concerns over the strength of the global economy are overdone and the likelihood of a recession is very low within the next two years. Forecasts for global GDP growth remain positive and we believe this elongated economic cycle has further to run.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Tavistock Wealth Limited and Lipper for Investment Management. Date of data: 17th January 2019
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