Q4-2018 Quarterly perspectivesTavistock Wealth - Investment Team Outlook
Welcome to the Q4-2018 ‘Quarterly Perspectives’ publication
Previous Quarter Review
Our decision to de-risk the portfolios during the quarter was prudent given the sell-off across global financial markets. We roughly doubled the allocation to cash and cash ‘plus’ securities, increased holdings in minimum volatility trading strategies and decreased exposure to both emerging market bonds and equities. Whilst emerging markets continued to weigh on performance, our new defensive cash positions, comprised of ultra-short bonds and floating rate debt, outperformed the benchmark. In equities, our overweight allocation to Japan also performed well as the Nikkei 225 rose to a 27-year high. During the quarter we reduced exposure to European equities, which underperformed slightly. We also initiated a new position in commodity equities via an ETF that tracks gold producers, which went on to outperform the benchmark.
There has been a stark divergence between equity markets in the US and the ROW (rest of the world) this year. Whilst US equities have powered ahead to fresh record highs, the MSCI World ex US has largely languished. This disparity has its roots in the strength of the US economy and perceived losers from the ongoing trade ‘war’. We think this trend will continue into 2019. Following the recent sell-off, we have revised our outlook for US equities to neutral and look to increase our exposure, via factor based tilts, on an opportunistic basis. Despite attractive valuations, we have reduced European equities to slightly underweight. Following a prolonged period of labour market tightening we may finally be seeing fledgling signs of inflation, which supports our forecast for further rate rises. We maintain our underweight allocation to developed market government bonds and have upgraded the outlook for cash ‘plus’ bonds and short duration US high yield debt.
Chart of the Quarter
US equities have dramatically outperformed the ROW this year with successive highs for the S&P 500 and tech-dominated NASDAQ index. However, we remain alert to the dangers posed from a sustained rise in 10-year US Treasury yields, which could reach 3.50% by Q1-2019. Higher yields have the potential to dent ‘growth’ stocks and precipitate a rotation within US equities towards ‘value’. As a result, we remain overweight factor based Smart Beta ETFs, which we believe will outperform the S&P 500 in the coming months.
In the face of further rate hikes globally, we are underweight government debt and prefer a barbelled approach comprised of cash ‘plus’ securities and short-dated corporate bonds. As part of our defensive strategy, we initiated new positions in ultra-short dated bonds and increased our existing exposure to floating rate debt, both of which have gone on to outperform the benchmark. We also like short duration US high yield, given the sector’s running yield. The current US corporate backdrop remains positive, with strong realised earnings growth, record setting services and manufacturing indicators and significant fiscal expansion. Volatility continues within European government debt markets.
Yields have risen across the board on the back of anti-establishment policy disputes with regulatory bodies, diverging core and headline inflation levels and ECB monetary tightening on the horizon. We remain underweight Europe in both the government and corporate sectors, seeing relatively better value elsewhere. Despite our view that the issues facing emerging markets are country specific, contagion spilled over to the more robust economies last quarter. Our decision to de-risk the portfolios, by reducing emerging market exposure, proved timely. Following the recent sell-off, we are now positioned slightly overweight emerging market debt as we believe the potential return now justifies the risk.
We prefer cash ‘plus’ strategies such as ultra-short bonds. These securities provide some protection from rising rates and inflation, while offering an attractive yield over term deposit rates. We also like US floating rate bonds, given that market expectations continue to lag an increasingly hawkish US Federal Reserve.
A stellar earnings season and strong economic data were the driving forces behind the US equity market last quarter, with the S&P 500 posting its best quarterly gain since 2013. Expectations going into this earnings season are high, leaving less scope for upside surprises. Our overweight allocation to Japan has benefited the portfolios as the Nikkei 225 hit a 27-year high. Shinzo Abe’s successful re-election has revived investor optimism over corporate reforms, giving further upside potential for Japanese equities. The Japanese yen also remains undervalued and will likely fuel additional gains.
Emerging markets have been hit by a range of idiosyncratic shocks. Countries with twin-deficits and large borrowings in foreign debt remain vulnerable to tightening financial conditions. We favour pockets of Emerging Asia where fundamentals are robust, although we are mindful of trade rhetoric and upcoming elections. Going into the 4th quarter, inflation expectations and Fed policy will dictate investor sentiment, with additional tail risks of trade tensions and the US mid-term elections. However, we do not believe the recent sell-off marks the end of the longer-term bull market.
US equities have historically continued to rally up to 6-months after the final rate hike of the cycle. We currently forecast an additional 4 rate hikes between now and the end of 2019, so there is more room to run.
Commodity markets continue to be one of the best performing asset classes so far this year, and we maintain our overweight assessment. Commodities typically outperform at the end of the economic cycle when demand outpaces supply. Strong global economic growth, depleting inventories and the potential for additional supply disruptions also underpin our bullish outlook. Oil prices recently hit a 4-year high, following the US placing sanctions against Iran, OPEC’s third-largest oil producer. Other oil producers have increased output to meet growing demand, but the sanctions are expected to impede global supply with predictions that oil prices could rise to $100 per barrel. We remain alert to the fact that history suggests $100 per barrel has tended to curtail economic growth.
This quarter we re-initiated a position in commodity equities via an ETF that tracks a basket of gold producers. Gold producers have underperformed dramatically this year. Valuations are now at attractive levels and the recent Barrick-Rangold merger could boost M&A activity. As we approach the end of this economic cycle, we believe gold’s safe haven status will become a broader investment theme.
Having previously sold at opportune levels, this quarter we re-initiated a position in commodity equities via a gold producers ETF which has gone on to outperform both the price of gold and the iShares MSCI World GBP Hedged ETF.
Sterling remains hugely undervalued against a basket of other major currencies and has a solid track record for bouncing back from previous periods of market stress.
Over the coming months, sterling will remain highly sensitive to the ebb and flow of the Brexit negotiations. Sterling has performed well of late, rising to a 4-month high against the euro and a 3-week high against the US dollar. This followed positive comments from EU negotiator Michel Barnier, who suggested a Brexit deal was now “within reach”. Brexit talks allegedly broke down recently over the main sticking point of the Irish border. EU negotiations always go down to the wire and this will be no different.
Whilst downside risks still exist, we believe a no deal outcome is largely priced-in. Finalising the withdrawal agreement and eliminating the uncertainty associated with a cliff-edged Brexit, will likely lead to significant appreciation in sterling. The UK pound remains fundamentally undervalued relative to historical moving averages and purchasing power and parity.
In early October, US equities suffered their worst declines since February 2018. The large rise in US government bond yields and profit-taking in the technology sector were the catalysts for the dramatic fall in global equity markets. This correction is significant, but we do not believe it signals the end of the 9-year bull market, given the growth outlook, low level of inflation and upbeat corporate earnings. We have been defensively positioned and have outperformed our global equity and bond benchmarks in the sell-off. Looking ahead, we will be monitoring economic data and markets closely, with the aim of increasing risk in the coming weeks. The 4th quarter will be key for the Brexit negotiations and the future direction for sterling.
The time for posturing is over and both sides appear to be showing a newfound willingness to compromise. We expect that a trade deal will be agreed by the end of November. The UK is the 5th largest economy in the world and has a trade deficit with the European Union, so it holds a strong bargaining position. Sterling has risen 1.50% versus the US dollar already this month and remains fundamentally undervalued. We expect sterling to appreciate by a further 10% during Q1 2019 and have hedged the portfolios to protect against any currency related losses.
With less than 6-months to go, Brexit is fast approaching. This timeline highlights the key dates in the UK’s withdrawal from the European Union.
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: 16th October 2018
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The US dollar index, which represents the value of the dollar against a basket of developed market peers, fell through key technical support to its lowest level in 2 years.
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