How last year's indicators have changed in 2019
The fund’s positioning enabled it to be part of the equities rally so far in 2019, but concerns remain about how global issues will affect the equities markets. Nevertheless, the results so far this year deserve some insight into how we are positioned, and where we expect opportunities to emerge.
Markets continued their rebound in February in spite of mixed economic data and slower corporate earnings growth. One positive through the month was the progress in trade talks between the US and China, as a previous March 1 deadline to increase tariffs on Chinese goods was postponed by President Trump. The US Federal Reserve (Fed) raised the prospect of targeting an average level of inflation over a cycle, which would allow for shorter-term overshoots above its 2% target. In the UK, Theresa May’s Brexit proposal was defeated in parliament as a number of conservative MPs abstained from the vote, with another round of voting set to take place during March. Nevertheless, the increased prospect of a delay to Brexit should no deal be reached saw the pound rally during the month. Domestically, increased uncertainty about global growth and weakening property prices has prompted the RBA to shift to a neutral stance on monetary policy, while money markets are pricing in one rate cut over the next 12 months.
Portfolio Activity and key themes:
While we have been adding to risk we have continued to be positioned on the cautious side, noting recently that there was a high risk that volatility would return. However, last month was one-way traffic with strong returns to risk assets and a continued fall in volatility. This market behaviour definitely raises questions about our outlook and therefore I would like to cover where we are in our thinking and how we are managing the portfolio in the current uncertain environment.
Halfway through last year we began to become concerned around the direction of the trade dispute between the US and China. We made three points: first, the market was underestimating the political momentum for an escalation, given President Trump’s need to motivate his base to vote in the mid-term elections. Second, the economic impact would be greater than expected; while we didn’t disagree with the medium-term impacts being modest, we thought the short-term impact would be more acute, due to the impact on corporate confidence from the increase in uncertainty and impact of re-jigging supply lines. Lastly, we concluded that the likely outcome was a ‘riot’ by equity markets as this is what is generally required to short circuit negative political momentum. In response to this view we cut our equity exposure in July, adding duration at the same time. In November we also increased the defensiveness of the fund by adding to our Japanese Yen exposure and adding further duration to the fund.
Given our broader view that a US recession was not in the time frame that generally concerns markets, we saw any market riot as an opportunity to add equity to the fund, on a tactical basis. However, while markets rioted as we expected, we only modestly upped our equity exposure, adding some direct equities late December and buying equity call options in early February. This reflected the view that volatility was likely to continue.
Relatively safe buying opportunities generally occur when there is capitulation. While we have seen capitulation — both on the market side, with the sharp fall in equities prior to Christmas, and in policy — there was a change in momentum in the trade dispute, the US Federal Reserve halted their rate rises, and China was stimulating their economy. However, we were not sure that the policy capitulation was enough to offset a weaker global growth environment. Manufacturing in the US has stalled related to the trade dispute, and while the US and China are likely to do a deal, the US still has issues with Europe with the potential for auto tariffs to be levied, suggesting some uncertainty remains. While the Fed and Chinese authorities have been supportive, the support has so far remained modest. Added to this is that equity market bottoms are generally not quick but develop over time, with re-tests of the initial low a common occurrence.
What is the risk we are wrong? If growth and confidence deteriorated due to the trade war and now with a deal likely and the uncertainty removed, they may recover quickly, which will see the equity market continue to rally from here. Given this is not a small probability, it is a risk we are trying to manage. First, it must be noted that we do have equities in the fund, so we will participate in an equity market rally. Also, the use of equity call options allows us to participate in the upside while limiting the downside risk. Second, the fund has positions reflecting a reflation theme, and given our view of higher US core inflation, this would likely be boosted by a recovery in confidence. Lastly, an important hedge against further equity market weakness, short Australian dollar/long foreign currency, may not be a drag if equities continue to rise, though given the weakness in the housing market, and subsequent negative wealth effect dragging on the economy, this positioning will keep the risk of an easing of policy by the Reserve Bank of Australia alive, thereby limiting the upside for the Australian dollar.
Overall we still believe in more volatility in the short run and thus have maintained our relatively defensive positioning. However, we are acutely aware of the risk of a continued improvement in business confidence and equity market performance. We are thus positioned to minimise the damage to the portfolio from another bout of equity market weakness, while still having enough risk to participate somewhat in a continued equity market rally.
After a difficult end to 2018, equity markets bounced strongly so far this year. The stand out performers during the month were the Chinese and Greek equity markets, both seeing double digit returns, head and shoulders above all the other markets. The Chinese market was supported by the positive momentum in the trade talks and policy easing, while news that Greece had submitted a plan to speed up bad loan disposal boosted its market. Most other markets posted returns in the +2% to +5% range with the Australian market performing slightly better.
While we did add back some equities close to the lows and in February added call options on the US equity market, we still remain relatively defensive with our base case another bout of volatility.
We still struggle with US equity valuations and our return forecasts remain close to 0% over our three-year horizon. We have a more constructive view on Japanese equities where valuations remain the most attractive in our framework and Australia where valuations are close to fair value, if not slightly cheap. Emerging markets are starting to look a little more interesting, but we would prefer to see more evidence of capitulation (and more attractive valuations) and/or confidence in a peak in the USD before buying.
Sovereign yields were more mixed in February. In the US, the bond market marked time following the Fed’s move to a more dovish tone in January. In Australia, continued weakness in confidence and further declines in house prices and housing activity saw the consensus begin to toy with the idea that the RBA will be cutting the official cash rate later in the year.
Credit performed well during the month as tighter credit spreads (consistent with the rebound in risk assets in January) continued.
During February, USD and GBP were the strongest performers. The GBP continued to rally as the likelihood of a delay to Brexit seems increasing likely; nevertheless it remains well below its longer run fair value. We maintain a small position in GBP on valuation grounds but are reluctant to increase this position as a potentially hard Brexit remains a real possibility. The AUD weakened in light of the RBA moving to a neutral stance on monetary policy and the yield spread between Australian and US 10-year bonds moving to their most negative level since the early 1980s.
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