Markets have stabilized and opportunities exist but could volatility become a recurring theme?
Investors had a rough ride in the fourth quarter of 2018, with a 17% peakto- trough decline in global equities followed by a 7% rebound into the
New Year. However, the decline in U.S. equities and the widening in investmentgrade credit spreads are similar to moves seen in previous post-2008 corrections.
In addition, most of the catalysts that were regarded as necessary for market stabilization materialized in December and January, including a less-hawkish tone at the Fed, lower equity valuations, a peak in the volatilitybased “fear gauge” and resolution of the Italian budget situation. These factors helped to stabilize the markets in late 2018, and an additional positive trigger emerged on January 4 with surprisingly strong U.S. non-farm payroll numbers, which allayed growing fears of an imminent U.S. recession.
As a result, foundations have been laid for market returns to be driven more by the fundamentals. However, bouts of 4Q18- style volatility will remain a feature across markets, and so risk management will remain an important part of investment decision-making going forward.
WHILE SELL-OFFS ACROSS all asset classes have been broad-based, the emergence of fundamental value has been more selective.
In fixed income, U.S. investment-grade bonds have seen spread-widening similar not only to that seen during post-2008 market corrections but also during the 1990 and 2001-02 U.S. recessions as well as the 1997-98 Asian financial crisis.
Admittedly, in absolute terms, this widening in U.S. investment-grade spreads has only taken them back to their historical average, and they have the potential to widen further, especially as recent jobs data suggests few signs of an outright recession in the U.S. economy.
Nevertheless, the risk/reward profile is now more balanced than at any time since 2015.
After weak performance in 2018, Japanese equities are pricing in a dire 2019. Valuations in Japan are lower than at any time since the depths of the global financial crisis, despite the fact that Japan has outpaced both the U.S. and European markets in terms of earnings and dividend growth over the past five years.
A strong yen is expected, which would represent a headwind for Japanese corporates. However, for non-JPY investors, prospective FX gains should contribute positively to total returns.
U.S. EQUITIES HAVE BEGUN TO overprice the prospect of a dramatic slowdown in U.S. economic growth, having seen P/E multiples fall below 15 times. However, earnings expectations remain overly optimistic for 2019, as evidenced by recent downgrades from high profile corporates. This trend should continue moving into late-January’s earnings season, hampering the early-2019 rally. As earnings are revised to more sustainable levels, investors should look to stock selection as the key driver of returns in the broader U.S. equity market.
Valuations in both China and emerging markets generally have long been attractive in both absolute terms and relative to developed-market equities. However, slowing economic and earnings growth and an unsupportive macro policy backdrop have prevented the emergence of catalysts for crystallising value present in these markets.
While a truce in the ongoing U.S.- China trade conflict in the coming months may boost sentiment, unless China adopts more stimulative domestic policies, that may serve only to stabilize the slowing Chinese economy. If the Chinese slowdown contines unabated in 2019, China would need to increase its efforts to support the economy, which could provide the catalyst that markets need.
In Brazil, the new government could adopt pro-cyclical policy measures initially, before pursuing the challenging reform issues outlined
during the campaign. Similarly, in India, with elections scheduled for May, pro-cyclical policies may be on the cards to buoy the economy.
If these pro-cyclical policies begin to appear in China, Brazil and India—the largest emerging economies—then EM valuation discounts may begin to reverse, both in absolute terms and relative to Western markets. They would also put the spotlight back on the growing supply/demand imbalances emerging in key industrial commodities around the world, and on the resulting opportunities for industrial
commodities prices and European metals and mining firms in the next few months.
ALTHOUGH INVESTORS SHOULD take comfort from the emergence of the catalysts needed to stabilize markets, the fundamental backdrop of a decelerating global economy and a more modest outlook for earnings remains in place. Although valuations are less extreme across asset classes, investors still have to contend with financial conditions that are tighter than at any time during 2017 or 2018. With most asset classes expected to deliver only moderate returns, these tighter financial conditions suggest that the 4Q18 volatility spike is unlikely to be a one-off, and could instead be a persistent feature of markets looking ahead.
As a result, investors should look to pivot portfolios from directional opportunities and instead consider alternative strategies (see p. 81), which should help to cushion returns during occasional periods of high volatility. In addition, opportunistically adopting strategies offering asymmetric exposure— capital protected or de-leveraged downside risk against upside participation in markets—could offer similar benefits to investors in volatile markets.
Norman Villamin Contributor
With over 20 years of experience managing wealth at Coutts International, Citi Private Bank, HSBC and Morgan Stanley, Norman Villiman is currently CIO Private Banking at UBP.