Welcome to the Q2-2019 ‘Quarterly Perspectives’ publication
Previous Quarter Review
As the first quarter ends, government bond markets are priced for recession. In the US, Treasury yields declined, prompting an inversion in the curve for the first time since 2007. Bond yields are already negative in Japan, whilst in Europe the 10-year Bund yield fell below zero for the first time since 2016. Meanwhile, global equities appear to be ignoring the warning signs flashing in the bond market and have risen more than 12% in 2019 – the best start to a year in two decades. Our preference for risk assets and pro-cyclical positioning benefited the portfolios which performed in-line with our high expectations. During the quarter we added new positions in commodity equities, emerging markets and increased exposure to long-dated government bonds.
The record-setting equity bull market in the US has further to run, but higher returns will likely come from markets in the UK, Europe and Asia, specifically China and India. A rotation away from the US will probably occur over the next 12-months, the speed of which will be heavily influenced by 2nd and 3rd quarter company earnings. Real yields are low or negative in many developed markets and represent a poor store of value rather than a source of positive return. The leveraged loan, high yield and BBB sector of the corporate bond markets are particularly vulnerable to any economic headwinds or rise in the default rate. Within the FX markets, sterling is significantly undervalued and should appreciate by year-end.
Chart of the Quarter
The US Federal Reserve has indicated a pause in the tightening cycle and the market has gone from pricing in 1-2 rate hikes to a rate cut. The rally in the US Treasury market seems excessive given that the Fed has stated that further policy movements will be data dependant. Job growth remains above trend, unemployment is low and inflation remains benign, so it’s too early to conclude that the next movement in interest rates is down.
The dovish pivot in global central bank policy contributed to strong first quarter returns in fixed income assets. Although we remain underweight duration, our decision to increase exposure to long-dated government bonds in Europe and the US contributed disproportionately to total performance. Ongoing concerns surrounding liquidity in corporate bond markets means we continue to favour short duration investment grade and high yield debt.
Within fixed income our preferred region is emerging markets. Our decision to switch from local to hard currency debt in the second half of last year has worked particularly well. Going forward, we believe the sell-off in certain emerging market currencies may provide an attractive opportunity for local currency debt later this year.
Liquidity is the major risk facing corporate bond markets. Over the last decade, changing regulatory requirements has contributed to a dramatic decrease in dealer inventory even as the value of outstanding US corporate debt has increased.
Global equities rebounded strongly to record their best first quarter in over two decades. It is likely that further price appreciation will be more measured going into the second quarter.
Although the economic fundamentals in Europe remain soft, we see the divergence in growth prospects between Europe and the US narrowing over the next 12-months. This could lead to investors rotating out of the US and into cheaper European equities.
Within equities, our preferred region is emerging markets, particularly China where sentiment surrounding the US-China trade talks remains positive. Stronger than expected PMI data, the inclusion of Chinese “A shares” in the MSCI EM index and accommodative policy out of Beijing should continue to support the asset class into Q2. We also like Indian equities, which should outperform in the run up to elections.
Within our core smart beta equity allocation, ‘quality’ remains our preferred factor. This is because corporations with strong balance sheets are better placed to withstand downward pressure on earnings growth during the late stages of the economic cycle.
US equities have delivered positive returns during previous periods where the Federal Reserve has paused or reversed interest rate hikes. This theme looks set to continue following the Fed’s decision to pause interest rate hikes in January.
Commodities have led this year’s market rebound following Q4 2018’s heavy losses. Optimism surrounding the US-China trade talks has bolstered the asset class, particularly in the energy and base metals sectors. We are positioned for a trade deal, which would be bullish for commodity markets. In the US, the Fed has gone into “patient” mode and announced that there will be no rate hikes in 2019. This dovish policy should lead to a marginally weaker dollar and higher commodity prices.
Oil prices have rallied for 4 straight months following OPEC+ cuts, US sanctions against Iran and Venezuela and growing (albeit slowing) global GDP. These drivers are expected to continue through Q2 2019. However, record crude production levels from the US may limit further price appreciation. This quarter we initiated a new position in an ETF which tracks companies in the global timber and forestry industries. These sectors are strongly correlated to housing and construction, emerging markets and a weaker US dollar – all of which stand to benefit from the Fed ‘pause’.
The Global Timber and Forestry ETF has lagged broader equity market gains so far this year offering considerable upside potential. This position is sensitive to global growth and should outperform in an environment of low interest rates and a return to above trend growth later in the year.
As Brexit uncertainty continues to fade we forecast further gains in sterling against the developed market currencies we actively hedge in the portfolio.
Despite falling US Treasury yields the US dollar has remained relatively strong given its positive yield differential relative to the rest of the world. The Japanese yen on the other hand has not fared so well given the resurgence in global risk appetite. The Euro also performed poorly this quarter, weighed down by deteriorating economic data in the region and ongoing political instability.
Sterling’s recent past and indefinite future continue to be defined by Brexit, as the uncertainty surrounding the UK’s departure from the EU remains as unclear as the day the UK made the decision to leave the union close to 3 years ago. Year-to-date sterling has made considerable gains against a basket of developed market currencies, benefiting our currency overlay strategy, which continues to protect the portfolios from excess levels of volatility.
The global economy decelerated in the 2nd half of last year and the International Monetary Fund recently revised its growth forecast downward from 3.5% to 3.3% for 2019. This is far short of predicting a recession and the dovish policy changes by the Fed and the ECB push the cyclical time frame back even further. Equity and bond markets performed very well during the 1st quarter and further price appreciation will be more measured. We are positioned for a positive outcome to the US-China trade talks and believe this will eventually lead to an increase in global trade. In this scenario, risk assets such as equities have further upside, however corporate bonds remain vulnerable given the size of the market and largescale refinancing requirements. Looking ahead, volatility is expected to rise and portfolio diversification between and within assets classes will be even more crucial in the coming months.
Over the next 5-years, equities are expected to offer greater risk-adjusted returns than fixed income. As a result we have increased our strategic risk allocation to this asset class. However, volatility is unlikely to stay at low-levels as we slowly return to historical norms, making tactical asset allocation decisions increasingly important.
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, Lipper for Investment Management and Thomson Reuters Datastream. Date of data: 18th April 2019 unless otherwise stated.
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