Investment Outlook 03.2019
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
Too good to be true?
The rally of risky assets continued in March, albeit at a slower pace. Most major equity markets performed positively, with the notable exceptions of the UK FTSE 250, which fell 0.3% and the Japanese Nikkei 225 index, which fell 0.8%. The S&P500 index slightly outperformed the MSCI Europe with 1.8% vs 1.6%. US tech stocks showed a sharp recovery in the first quarter and gained more than 20%. Chinese stimulus measures and improving economic data pushed the CSI 300 up by 5.5% in March, which brings the Q1 performance to 28.6%. The broad emerging markets index was up by 0.7%.
Credits rallied in tandem with equity markets. In March the high-yield index rose 0.78% and the emerging-markets hard-currency bond index 1.4%.
Usually, when risky assets rally, government bonds tend to lose value. In Q1, however, and especially in March, bonds rallied together with risky assets, driven by dovish central banks. In Q1 10-year yields fell about 30 basis points, both in the US and in the Euro area.
The broad commodities index fell slightly, by 0.2%, in March. Oil and other energy commodities continued to rise, with Brent oil gaining 3.6% in March. Optimism over US-China trade talks and the political situations in Venezuela and Libya pushed oil prices higher.
REITS had another strong month. The global REITS index rose 4.5%. With a Q1 gain of almost 16.0%. REITS have been one of the top-performing asset classes this year.
The USD remained on the strong side in March, gaining 1.3% against the EUR and 1.7% against the GBP. It fell, however, 0.5% against the JPY. The GBP traded sideways relative to the EUR, after it had advanced about 5% during January and February, despite Brexit uncertainties. The CHF gained 1.6% vis-à-vis the EUR, probably driven by a more dovish ECB.
The macro outlook is not entirely clear and shows diverging trends. The US economy, which slowed in Q4 2018 and at the beginning of 2019, has stabilized and is widely forecast to grow at about trend. The European economy continues to slow, however. The European manufacturing PMI even fell below 50 (the growth threshold) in February and softened further in March, reaching 47.5.
Meanwhile, the most positive recent development has been the recovery of Chinese leading indicators. For example, the Caixin PMI rose to 50.8 in March, breaking above the 50 level after having fallen below 50 in December. In addition, German leading indicators, like the ZEW and the IFO indices, which are sensitive to a better outlook for exports, have recently recovered. So far it is too early to state that China has made a clear recovery, which would carry the potential to revive other emerging markets and export-dependent Europe. But at least the state of the Chinese equity market, which gained more than 30% this year, suggests that there is a lot of optimism among investors.
However, markets remain vulnerable to geopolitical risks. Above all, the Sino-US trade dispute could put the brakes on the positive momentum we enjoyed in Q1. The rivalry between the US and China will not disappear anytime soon. However, for the short term, we continue to see a strong likelihood of a positive outcome to the trade talks. We think that the two leaders, President Trump and President Xi Jinping, currently have powerful incentives to find some kind of solution. President Trump, who is fighting to be re-elected on 3 November 2020, wants to avoid a bear market and an economic down-turn. President Xi Jinping may not be facing similar pressures, but stabilizing the fragile Chinese economy is very high on his agenda. In line with these facts, Matt Gertken, the chief geopolitical strategist of BCA, sees a 70% probability of a trade deal happening this year.
At its 19-20 March policy meeting the US Fed kept rates unchanged. The Fed expects stable growth and well-anchored inflation. This was widely seen as confirmation of a soft Fed policy. However, the Fed meeting minutes, which were published on 10 April, revealed that Fed board members are keeping their options open. Several Fed members were reported as stating that their view regarding the appropriate interest rate could shift in either direction. Some members said that they would regard a rate rise as appropriate if economic conditions remained unchanged. Shortly after the publication of the Fed minutes, the market-implied probability of a rate cut at or before the December meeting fell from almost 56% to about 40%.
Jerome Powell came under repeated pressure from President Trump to loosen monetary policy and cut rates. Similar attempts to influence central banks have recently been made in Turkey and India. This imposes a clear threat to central banks’ independence, which is a corner-stone of modern monetary policy. The central banks’ ability to steer monetary aggregates and inflation rests on the credibility and sovereignty of the central banks.
On April 10 the ECB held its monetary policy meeting and decided to keep rates unchanged “… at least through the end of 2019, and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2%, ..”. Further, the ECB will continue to reinvest the principal payment from maturing securities for an extended period of time and will introduce a new series of targeted longer-term financing operations (LTRO-III). The ECB sees that “The risks surrounding the euro area growth outlook remain tilted to the downside, on account of the persistence of uncertainties related to geopolitical factors, the threat of protectionism and vulnerabilities in emerging markets.” It was a no-surprise meeting, but clearly implies that the accommodative stance of the ECB will continue well past the tenure of President Draghi, which will end in October.
Is the market development in Q1 too good to be true? We believe not necessarily. If the world economy stabilizes and China achieves a sustained revival of its own economy, we may see the rally continuing. With hindsight, Q1 may be seen merely as a reversal following extremely oversold markets in Q4 2018.
However, we think it is advisable to remain cautious and prepare for an equity market correction later this year. First, geopolitical risks remain elevated. It seems that, for now, President Trump is facing stronger headwinds from the democrats, who hold the majority in the house of representatives, and he may want to avoid risks to the economy and the stock market in anticipation of the upcoming elections in November 2020. Nevertheless, he may re-surface with a more aggressive stance during the pre-elections to gain support from his voters. Second, as discussed above, the macro picture is not so clear and we could see disappointing earnings or macro indicators during the course of this year. Third, in our view, recent market moves reflect a lot of optimism regarding macro-economics, geopolitics, and central banks’ support. Therefore, we are very cognizant of a large potential for disappointment, which could trigger a severe market correction.
As a result, we remain cautiously positioned, underweighting interest rate and credit risks. We remain neutral on equities and slightly overweight on energy. In the first quarter we gradually reduced the energy overweight to realize gains. The same applies for the equity-market gains.
In addition, we have decided to use a part of the portfolio gains to hedge about 40% of the equity quota. This hedging measure consists of a basket of put options and will offset a proportion of the losses that would be incurred in the event of a share-market correction.