November positives hard to come by

After the sharp rise in volatility in October, markets stabilised somewhat in November, with political events the main new news over the month. The US mid-term elections were held on November 6 and while Republicans maintain control of the Senate, the Democrats won control of the House. With this comes control of the various House committees, which will see a significant rise in scrutiny of President Trump and his administration. UK PM Theresa May announced a Brexit deal, which led to several of her ministers resigning. While the deal was approved by the EU, the main sticking points will be getting the agreement through the UK parliament. The US Federal Reserve's Chair Jerome Powell, also helped to provide some stability, by noting that the official cash rate was just below estimates of neutral, suggesting an end to their rate hike cycle may be nearer than markets expected. This was supported by recent falls in the oil price, which will dampen inflation in the near term.

Global equities bounced in November, offsetting a small amount of the October fall, rising by 1.2% in local currency terms. On the other hand, the Australian equity market fell in the month and was the worst performing major market, ending November with a -2.2% return. Government bond yields in major markets fell over the month. US 10 year yields 0.16% lower in November, ending the month at 2.99%. German and Japanese yields fell by 0.07% and 0.04% respectively. Australian bond yields fell marginally ending the month 0.03% lower at 2.59%. Credit markets came under pressure, with high yield credit posting negative returns, and investment grade bonds underperforming relative to government debt.

Last month we noted that having further de-risked in July, we saw this correction as likely to provide a tactical buying opportunity for risk assets given the broader structural risk to equities posed by a potential US recession was still more likely a 2020 story. This remains our base case, but we have also remained on the sidelines, which so far at least has proven to be the right strategy.

Our ongoing, near term caution reflects both fundamental and technical factors. On the fundamental side are still stretched US equity valuations, ongoing trade tensions, some softening in the pace of growth (especially in US housing), and more broadly a contraction in global liquidity. From the technical side the relative narrowness of the pull back in risk assets (mainly equities to date) and the absence of major investor capitulation have suggested to us this correction has further to run. We concede that getting the timing precisely right on these things is inherently difficult, but at this point in the cycle, we’d rather be cautious.

It's worth highlighting that there have been some “new” developments and some ongoing but less visible issues that muddy the waters.

Firstly, since peaking in early October, the oil price has fallen by 1/3, significantly reducing pressure on headline inflation, and indirectly and over time taking some of the heat out of the broader inflation pulse. While this may take some pressure of the Fed as it contemplates the trajectory of US monetary policy from here, its bad news for energy producers and this is being felt in credit markets (particularly high yield). Secondly, global liquidity is contracting as both central bank balance sheets contract and as bank lending moderates. This credit contraction is bad news for banks and other lenders and bank share prices (particularly in Europe) have fallen sharply. Markets have been awash with liquidity for a number of years and this has papered over a multitude of problems as access to capital and the risk premium associated with it has been distorted. While hard to pinpoint exactly, the potential for a flashpoint somewhere is high. The market’s response to this would likely be significant in the short run, but potentially force a more constructive policy response (i.e. cause the Fed to ease). We have already seen the Fed slightly modify its rhetoric suggesting financial conditions are impacting their thinking even if their base line course of action is to continue tightening.  

We did make some modest changes to positioning in November, essentially adding additional downside protection / risk hedges. Specifically, we added some outright duration through US Treasury bond futures, we halved our short A-REIT / long SPI futures position on the basis that this is effectively high beta duration proxy and sensitive to the direction of the bond market, and added addition JPY exposure (a typically outperformer in periods of volatility). We expect these positions to help insulate the portfolio if there were to be another down leg in risk assets, and from a timing perspective, both the JPY and US Treasury response had lagged the weakness in equities.

With regards to the outlook from here, there are some specifics to each asset class that we’re wary of. 

In equities, markets had a mixed November. The US, Japan and Emerging markets bounced following October’s weakness, while Australia and Europe posted further losses (-2.3% and -0.9% respectively). For those markets that did rise, the gains relatively modest given the extent of the October falls and in most cases had more of a “dead-cat” feel to it.

November’s returns did little to turn the tide on what has been a tough year for equity markets. Of the major markets, the US is the only market with positive returns this calendar year. Other developed markets have returns in the red to the tune of between -2.5% (Australia) and -5.6% (Japan). Emerging markets are down around -7.5% reflecting amongst other things a stronger US dollar and the spill-over effects of the US-China trade war.

We adopted a very defensive stance towards equities in July and have held this position through the recent volatility. We continue to look for a re-entry point but would see this as a tactical buying opportunity only. While the US is setting the current tone, it remains our least preferred equity market in a medium term context given its structural overvaluation and overheating economy. Our preferred markets remain Australia and Japan given their relative cheapness. 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 a peak in the USD before buying.

In fixed income,sovereign yields moved with a broad(ish) range in November. The key US Treasury market initially saw yields rise to near cycle highs before rallying into month end as the Fed hinted at a more moderate US monetary tightening cycle amid declining oil prices, moderating liquidity and increased volatility in equity markets.

Sovereign yields in Australia also narrowed over the month, on the back of global trends as well as benign wage and inflation conditions that suggest the RBA is firmly on hold.

After an initial rally, credit spreads widened in November with credit starting to catch up to equities. While the rise in investment grade spreads was relatively orderly (and modest), high yielding credit saw greater volatility as sharp decline in oil prices also impacted.

Finally, currencies were mixed in November. A slightly weaker USD (against a slight shift in rate expectations and a softening in US growth) saw the AUD gain modestly as did the JPY. That said the Australian dollar was still down around 10% from its January peak and has provided an important offset to weaker and more volatile equity markets over this timeframe. We continue to view a short AUD and long JPY position as good risk hedges. While we continue to like GBP on valuation grounds, it struggled in November amid the messy Brexit “deal”.

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