Q3-2019 Quarterly perspectives

Tavistock Wealth - Investment Team Outlook

Welcome to the Q3-2019 ‘Quarterly Perspectives’ publication

First Half Review

The first half of 2019 may be the best start to a year of all time. Global equities added $8 trillion in value, bonds surged (as yields plummeted) and oil prices rose by almost a quarter. What has been particularly impressive, other than the magnitude of the gains, is how broad they have been across markets, regions and asset classes. The two key drivers are stimulus from China and the dramatic change of direction by the US Federal Reserve, which is now communicating rate cuts instead of hikes. Our preference for risk assets and pro-cyclical positioning benefited the portfolios which delivered strong performance in both absolute terms and relative to the benchmark. During the period we increased exposure to high-yield debt and emerging markets via local currency debt and equities.

Key Themes

Our key theme for the second half of 2019 is US dollar weakness. There are a number of signs indicating the US dollar may have reached a near-term peak. These include the dollar cycle, which is due to move lower, lofty valuations and interest rate differentials that show the Fed has more room to cut rates relative to its peers. The weaker US dollar will benefit risk assets such as commodities and equities. Within equities we like emerging markets which are negatively correlated to the US dollar and trade at a discount to developed markets. We prefer a selective approach to commodities with a preference for gold. In fixed income, we like emerging market local currency debt which offers an attractive yield and the potential for currency appreciation.

Over the last few weeks the US dollar Index broke out of its recent channel and below the 200-day moving average.

Chart of the Quarter

We believe trade tensions between the US and China will continue over the long-term. This chart shows how Q1 trade, relative to one year ago, has shifted from China to other emerging markets.

Fixed Income

The rally in fixed income assets, fuelled by central bank dovish sentiment, has compressed credit spreads and lowered the yields on government bonds. Our overweight position to long-dated European debt significantly outperformed the benchmark last quarter as German and French yields reached record lows. We recently took profit on this position and invested the proceeds in European inflation-linked government bonds. We believe loose monetary policy, a weaker US dollar and the bottoming-out in European economic data should lead to a pick-up in inflation expectations.

Over the course of the quarter, we rotated our emerging market exposure from hard to local currency government debt. The weaker US dollar, strong current and fiscal fundamentals and supportive fund flows point to ongoing out performance.

Within our high yield exposure, we are positioned in the highest level of the sub-investment grade credit ratings. BB-rated credit has outperformed lower rated fixed income securities over the past 12 months and this is a trend we believe will continue going forward.

We have allocated 75% of our high yield benchmark allocation to ‘fallen angels’ which are companies at the top end of the junk bond market. This provides some degree of credit protection whilst also allowing us to take greater duration risk relative to the benchmark.

Equities

Global equities maintained their momentum from Q1, with the S&P 500 and Nasdaq 100 indices both reaching record highs. Equity returns for next quarter will be underpinned by a return to quantitative easing and lower short term rates.

The optimistic sentiment that emerged from the Trump-Xi meeting at the G20 summit has set a positive tone for equity markets going into Q3. We maintain a bullish outlook on Chinese equities as they will be the main beneficiaries of dissipating trade tensions, especially given their attractive relative valuations. Our position in S&P technology posted strong gains on the back of the recent risk-on sentiment with further gains dependent on the upcoming earnings season.

The prospect of a softer US dollar will be a tailwind for emerging markets. In addition to emerging Asia, we favour Latin American equities including Mexico (pending USMCA trade deal ratification) and Brazil, where pension reforms should boost longer term economic growth prospects.

Within our core smart beta allocation ‘quality’ remains our preferred factor as it continues to trade at attractive valuations and tends to outperform late-cycle.

This chart highlights the strong negative correlation between emerging market performance and the US dollar index. Historically, periods of US dollar weakness have coincided with equity market gains. Conversely, periods of US dollar strength have coincided with equity market weakness.

Commodities

We remain bullish on commodity markets, which are historically cheap compared to equities. Commodities are inversely correlated to the US dollar and typically outperform at the end of the economic cycle when demand outpaces supply.

Over the first half of 2019, the S&P Goldman Sachs Commodity Index rose 13.34%, led higher by the energy and precious metal sectors. Heightened tension between the US and Iran and a fall in US domestic stockpiles sent oil prices higher. We are positioned for a further rise in oil prices due to continued geopolitical tensions via our satellite exposure to Russian equities.

We currently favour a selective approach to commodities. Our preferred commodity play is gold (via our equity position in gold mining companies), which has performed exceptionally well since inception. Gold prices have broken above the 5-year resistance level of $1,350 per ounce and we forecast further upside gains relative to the benchmark. A sustained break higher towards $1,800 per ounce would likely require US real- yields to fall further.

As shown in the chart, the relative performance of commodities to US equities follows a 10-15 year cycle. Commodities are currently at the bottom of this cycle and historically cheap relative to US equities which are expensive.

Foreign Exchange

Interest rate differentials explain the majority of long-term FX moves. However, since the end of last year there has been a divergence between GBP/USD and the spread between 2-year UK Gilts and US Treasury yields. This deviation is most likely the result of greater uncertainty related to Brexit. We expect this divergence to converge over time as Brexit uncertainty fades. Should interest rate differentials re-establish themselves as the primary driver of FX moves, we expect GBP to rise towards 1.40 versus the US dollar.

Ethical Investing

There is a growing recognition that ethical investing (inclusive of ESG & SRI themes) represents an important source of growth for the fund management industry. The transition to ethical investing is underway, thanks to several structural tailwinds. Addressing the ambiguity of interchangeable terms like ethical, responsible and impact investing, financial regulators and ratings agencies have been working to establish comprehensive standards and rigorous, quantitative ratings methodology. Electorates, governments and central banks the world over are on-board, and it has become clear to fund managers that it is now a greater risk to ignore ethical issues than to embrace them. As the transition matures, it is possible to back test the performance of ethical investments. The results are stark, especially so in emerging markets. ‘Best-in-class’ SRI investments have increasingly outperformed their traditional peers, primarily due to the quality controls associated with ethical investment criteria. Combine robust financial outperformance, improving methodology & regulation and growing demand for ethical investments (particularly among younger generations), it is easy to see why AUM with an ‘ethical mandate’ have ballooned to $12tn. There is no reason to suggest this transition will taper off anytime soon.

Final Thoughts

The easy monetary policies pursued by the PBOC, ECB and US Federal Reserve represent a return to the Goldilocks scenario in which both bond and equity prices trade higher. Low inflation will underpin bond yields in the near-term. Equity markets have recovered from their fourth quarter losses and the rally has further to run. A successful conclusion to the US-China trade negotiations will extend the life of the longest equity bull market on record. The portfolios are fully invested and tilted towards risk assets. Our biggest call entering the second half of the year is for a gradual weakening of the US dollar. This will benefit emerging market bonds and equities, especially in China, Russia, Brazil and Mexico. Looking to the future, ethical investments such as green bonds or SRI equities will become larger allocations within the portfolios, especially given that they represent another important layer of diversification and source of alpha.

Assets invested in sustainable mutual funds and ETFs are forecast to grow considerably over the next decade representing a unique opportunity in the asset management sector.

First Half Review

The first half of 2019 may be the best start to a year of all time. Global equities added $8 trillion in value, bonds surged (as yields plummeted) and oil prices rose by almost a quarter. What has been particularly impressive, other than the magnitude of the gains, is how broad they have been across markets, regions and asset classes. The two key drivers are stimulus from China and the dramatic change of direction by the US Federal Reserve, which is now communicating rate cuts instead of hikes. Our preference for risk assets and pro-cyclical positioning benefited the portfolios which delivered strong performance in both absolute terms and relative to the benchmark. During the period we increased exposure to high-yield debt and emerging markets via local currency debt and equities.

Key Themes

Our key theme for the second half of 2019 is US dollar weakness. There are a number of signs indicating the US dollar may have reached a near-term peak. These include the dollar cycle, which is due to move lower, lofty valuations and interest rate differentials that show the Fed has more room to cut rates relative to its peers. The weaker US dollar will benefit risk assets such as commodities and equities. Within equities we like emerging markets which are negatively correlated to the US dollar and trade at a discount to developed markets. We prefer a selective approach to commodities with a preference for gold. In fixed income, we like emerging market local currency debt which offers an attractive yield and the potential for currency appreciation.

Over the last few weeks the US dollar Index broke out of its recent channel and below the 200-day moving average.

Chart of the Quarter

We believe trade tensions between the US and China will continue over the long-term. This chart shows how Q1 trade, relative to one year ago, has shifted from China to other emerging markets.

Fixed Income

The rally in fixed income assets, fuelled by central bank dovish sentiment, has compressed credit spreads and lowered the yields on government bonds. Our overweight position to long-dated European debt significantly outperformed the benchmark last quarter as German and French yields reached record lows. We recently took profit on this position and invested the proceeds in European inflation-linked government bonds. We believe loose monetary policy, a weaker US dollar and the bottoming-out in European economic data should lead to a pick-up in inflation expectations.

Over the course of the quarter, we rotated our emerging market exposure from hard to local currency government debt. The weaker US dollar, strong current and fiscal fundamentals and supportive fund flows point to ongoing out performance.

Within our high yield exposure, we are positioned in the highest level of the sub-investment grade credit ratings. BB-rated credit has outperformed lower rated fixed income securities over the past 12 months and this is a trend we believe will continue going forward.

We have allocated 75% of our high yield benchmark allocation to ‘fallen angels’ which are companies at the top end of the junk bond market. This provides some degree of credit protection whilst also allowing us to take greater duration risk relative to the benchmark.

Equities

Global equities maintained their momentum from Q1, with the S&P 500 and Nasdaq 100 indices both reaching record highs. Equity returns for next quarter will be underpinned by a return to quantitative easing and lower short term rates.

The optimistic sentiment that emerged from the Trump-Xi meeting at the G20 summit has set a positive tone for equity markets going into Q3. We maintain a bullish outlook on Chinese equities as they will be the main beneficiaries of dissipating trade tensions, especially given their attractive relative valuations. Our position in S&P technology posted strong gains on the back of the recent risk-on sentiment with further gains dependent on the upcoming earnings season.

The prospect of a softer US dollar will be a tailwind for emerging markets. In addition to emerging Asia, we favour Latin American equities including Mexico (pending USMCA trade deal ratification) and Brazil, where pension reforms should boost longer term economic growth prospects.

Within our core smart beta allocation ‘quality’ remains our preferred factor as it continues to trade at attractive valuations and tends to outperform late-cycle.

This chart highlights the strong negative correlation between emerging market performance and the US dollar index. Historically, periods of US dollar weakness have coincided with equity market gains. Conversely, periods of US dollar strength have coincided with equity market weakness.

Commodities

We remain bullish on commodity markets, which are historically cheap compared to equities. Commodities are inversely correlated to the US dollar and typically outperform at the end of the economic cycle when demand outpaces supply.

Over the first half of 2019, the S&P Goldman Sachs Commodity Index rose 13.34%, led higher by the energy and precious metal sectors. Heightened tension between the US and Iran and a fall in US domestic stockpiles sent oil prices higher. We are positioned for a further rise in oil prices due to continued geopolitical tensions via our satellite exposure to Russian equities.

We currently favour a selective approach to commodities. Our preferred commodity play is gold (via our equity position in gold mining companies), which has performed exceptionally well since inception. Gold prices have broken above the 5-year resistance level of $1,350 per ounce and we forecast further upside gains relative to the benchmark. A sustained break higher towards $1,800 per ounce would likely require US real- yields to fall further.

As shown in the chart, the relative performance of commodities to US equities follows a 10-15 year cycle. Commodities are currently at the bottom of this cycle and historically cheap relative to US equities which are expensive.

Foreign Exchange

Interest rate differentials explain the majority of long-term FX moves. However, since the end of last year there has been a divergence between GBP/USD and the spread between 2-year UK Gilts and US Treasury yields. This deviation is most likely the result of greater uncertainty related to Brexit. We expect this divergence to converge over time as Brexit uncertainty fades. Should interest rate differentials re-establish themselves as the primary driver of FX moves, we expect GBP to rise towards 1.40 versus the US dollar.

Ethical Investing

There is a growing recognition that ethical investing (inclusive of ESG & SRI themes) represents an important source of growth for the fund management industry. The transition to ethical investing is underway, thanks to several structural tailwinds. Addressing the ambiguity of interchangeable terms like ethical, responsible and impact investing, financial regulators and ratings agencies have been working to establish comprehensive standards and rigorous, quantitative ratings methodology. Electorates, governments and central banks the world over are on-board, and it has become clear to fund managers that it is now a greater risk to ignore ethical issues than to embrace them. As the transition matures, it is possible to back test the performance of ethical investments. The results are stark, especially so in emerging markets. ‘Best-in-class’ SRI investments have increasingly outperformed their traditional peers, primarily due to the quality controls associated with ethical investment criteria. Combine robust financial outperformance, improving methodology & regulation and growing demand for ethical investments (particularly among younger generations), it is easy to see why AUM with an ‘ethical mandate’ have ballooned to $12tn. There is no reason to suggest this transition will taper off anytime soon.

Final Thoughts

The easy monetary policies pursued by the PBOC, ECB and US Federal Reserve represent a return to the Goldilocks scenario in which both bond and equity prices trade higher. Low inflation will underpin bond yields in the near-term. Equity markets have recovered from their fourth quarter losses and the rally has further to run. A successful conclusion to the US-China trade negotiations will extend the life of the longest equity bull market on record. The portfolios are fully invested and tilted towards risk assets. Our biggest call entering the second half of the year is for a gradual weakening of the US dollar. This will benefit emerging market bonds and equities, especially in China, Russia, Brazil and Mexico. Looking to the future, ethical investments such as green bonds or SRI equities will become larger allocations within the portfolios, especially given that they represent another important layer of diversification and source of alpha.

Assets invested in sustainable mutual funds and ETFs are forecast to grow considerably over the next decade representing a unique opportunity in the asset management sector.

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 Refinitiv Datastream. Date of data: 16th July 2019 unless otherwise stated.

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