US: Fed and economy downgrade play key roles

While not always easy to do, I generally try not to spend too much time on Sundays thinking about economics and markets, particularly when the sun’s shining and all seems good with the world. My best endeavours were tested on the weekend when my daughter’s mid-20s boyfriend challenged me with the relatively tough question of when there would be a recession, whether there could be another Great Depression, and, whether his super balance could fall 80% – like it would under a depression scenario. Weekend over!

My responses were along the lines of a recession in 2020 was certainly possible, a depression unlikely in the next couple of years given the fact that central banks and governments had not quite run out of bullets yet, and we shouldn’t underestimate their determination to kick the can further down the road. I also said that while he should expect to see the balance in his growth-oriented super account decline (possibly sharply), given his age, account balance and the general uncertainty over what the superannuation rules would be in 40 years’ time when he might be able to access it, that he might be better to ride it out (and of course that he should really see a financial adviser). With such a long investment horizon, and the dangers of getting whipsawed, I couldn’t see a strong case to switch his balance (as he’d suggested he might) into cash/term deposits.

This was an interesting conversation for several reasons.

Firstly, it reflected a growing sense of unease about both the economic and market outlook, fuelled amongst other things by increased market volatility and falling house prices (and increasingly pessimistic forecasts of where they end up). For those of us with residual grey hairs (well what’s left anyway), neither are new nor too surprising. In fact, it’s the lack of volatility in markets and the perpetual rise in house prices that preceded more recent events that seems more unusual.

Secondly, while a classic long horizon investor who should (in theory) be comfortable with the volatility of a high growth portfolio, I was surprised by his sensitivity to the path his returns might take should recession and a bear market unfold. He may well represent an outlier within his age cohort, but his concern is legitimate. For older investors (say those much closer to retirement) with both less time and income/savings potential to recover, this is a much more significant problem. 

Last year wasn’t a great year for investors – in fact a positive return, no matter how small, was good. That said, there were some positives. Firstly, it reminded investors that assets have risk and we should demand a premium commensurate with this risk for taking it. Secondly, it gave us a glimpse into what a future without central bank support might look like. Here I’d highlight the fact that while equities (particularly US equities) have performed well for the past few years, this performance has been exaggerated by extremely accommodative monetary policy and excess liquidity globally. The role of central bank balance sheet expansion on both price appreciation and volatility suppression shouldn’t be underestimated. While markets “rioting” may have called the Fed’s bluff for now, this may not endure, particularly if inflation does start to rise again.

What this means is that what worked during this period probably won’t work as well going forward. Recent volatility may have improved somewhat future return prospects from some assets but it hasn’t fundamentally changed the outlook. Bond yields are very low, credit spreads are narrow and valuations (particularly for the key US equity market) are still consistent with very low, medium term returns. If we assume (as is our base case) that we see a recession in the US (and fallout globally) within the next 3 years then at some point risk assets could take a tumble.

So, if I was 25 (like my daughter’s boyfriend), I might consider closing my eyes and holding on for the ride. But, if I was closer to retirement, then thinking about the path risk in my portfolio (and in fact the dependence on the recent past repeating) would be much more critical.

Timing is everything of course. We might have some time to prepare (thank you 2018 for the warning), but not too much.

In terms of the Real Return strategy, we added 2.5% to the equity position at the end of December but have not added further as we expect another opportunity to add in the next month or two. As we have noted for some time, we believe this will be a tactical opportunity to add risk and expect to be becoming defensive again sometime later in the year.  We did reduce slightly the strategy’s global high yield debt exposure given the retracement in high yield spreads and some concern about deteriorating quality in the high yield loan market, which would likely have a contagion effect on high yield bonds.

Market Outlook:

Equity

After a difficult end to 2018, equity markets bounced in January with the major markets posting solid gains. The strongest performers during the month were Hong Kong, Korea and the US (especially the Nasdaq which posted gains of just under 10%). The UK, Japan and Australia also posted respectable gains, but in the low/middle single digits.

While we did add back some equities close to the lows and in low volume around year end, we believe this rally owes more to short covering by institutions such as hedge funds, rather than being more fundamentally anchored. That said, with US Federal Reserve opting for a more dovish stance at its January meeting, the notion of the “Powell put” has given some temporary energy to the market.

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 have significantly improved (with PEs now at their lowest level since the 1970s) 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.

Fixed Income

Sovereign yields moved lower in both the US and Australian markets. In the US, the Fed’s more dovish tone and softer macro data (particularly on the production side of the economy) saw yields decline across the curve. In Australia, softening confidence at both the business and consumer level as well as continued declines in house prices and housing activity saw the consensus shift to a slight easing bias in Australia. We think a rate cut is more likely than a rate rise in the near term, but the RBA would be reluctant “easers” so the hurdle for a rate cut is still probably quite high. 

Credit performed well during the month as lower sovereign yields and tighter credit spreads (consistent with the rebound in risk assets in January) combined. Most of the action in credit markets was offshore though with local spread moves more benign. 

Currency

The main theme in currency markets in January was the weaker USD, which was reflected against the AUD, the Euro and the JPY. While GBP had a modest rally on the back of the UK parliamentary vote against Teresa May’s Brexit plan, uncertainty over the path of Brexit and the potential for a “hard” exit have held things back. We like the GBP on valuation grounds but with a hard Brexit a real possibility, we are reluctant to take any more than a small position. We continue to view a short AUD and long JPY position as good risk hedges.

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