At the start of 2018, we communicated about this being a transitional year, from a ‘Goldilocks’ period to a more challenging economic and financial environment. While we believed economic growth would remain above potential, our concerns stemmed around inflation pressures and tightness in financial markets after years of monetary policy normalisation. In September (see Smoke on the Water), we noted that the balance of risks was shifting to the downside and that a host of idiosyncratic risks could morph into a systemic risk for growth assets. We are now seeing that fundamentals, which remain positive, may not be sufficient to support markets. Looking ahead, our central scenario has shifted recently from a cautious, pro-growth tilt to a defensive, risk-off posture.
Many downside triggers, few upside ones
A few numbers to put this year into perspective: in total return terms, the MSCI AC World Index has shed 3.1%, with the MSCI World Index (developed equities) down 1.7% and the MSCI Emerging Markets Index down 13%. The Bloomberg Commodity Index has returned -3.2%, while the Barclays Global Aggregate Bond Index is flat and the Barclays Inflation-Linked Bond Index has returned -4.2%. The US dollar has been the rare outperformer, with the DXY Index up 4.7% year to date.
Clearly, the market has digested a host of downside risks already, from trade war tensions, to a slowdown in China, to geopolitics. However, looking ahead, there are still negative triggers that the market is not fully pricing in:
- Monetary policy mistake: the rather hawkish tone of the Fed over the last few months has already drawn investor concern, but the market is pricing in one to two fewer hikes than the median Fed projection for 2019 and two to three fewer hikes by 2020. As we communicated last week, it is not wise to fight the Fed.
- Geopolitics: whether it is the still-unknown outcomes of Brexit, the Italian government’s face-off with the EU or a newly energised US Democratic party, politics will likely add uncertainty to markets over the next few months, not remove it.
- Deteriorating growth: while investors have repriced the growth premium to a degree – e.g., our growth basket is down 1% this year – we believe further repricing is ahead. Our Growth Nowcaster had been supported in 2018 primarily by the US. But with the impact of the tax cuts behind us and rising financing costs for households and businesses (the 30 year mortgage rate and spread on high yield corporate debt are both up nearly 1% this year), we have seen a meaningful slowdown in US consumption (both durable and non-durable goods) over the last few weeks. A sustained lower price for oil would provide support for global demand, but will not be sufficient alone to lift growth back to the highs seen earlier this year.
In terms of positives, the only one we see is a thawing of trade tensions and a potential framework for a trade deal when Trump and Xi meet at the G20 summit later this month. But it’s important to remember that there are fundamental differences behind the trade dispute that will hinder reaching an accord. The two nations have antithetical views on the role of government in business, do not see eye-to-eye on the value of intellectual property and are vying for global power and influence.
Our central scenario for upcoming months is risk-off
This asymmetry in risks motivates our shift to a defensive posture. Our base case now is for the global economy to see a meaningful slowdown from current levels, though to be clear we are not expecting a recession on the horizon. For central banks such as the Fed, this would be a positive development as it would help curtail inflation risks and explains why we do not believe the Fed will deviate from its communicated policy path. However, such a slowdown would be a negative surprise for market participants who are expecting growth to be in line with 2017 and 2018 levels: Bloomberg Consensus Estimates of global growth in 2019 stands at 3.6%, compared to realised growth of 3.7% in 2017 and forecasted growth of 3.8% for 2018.
Furthermore, we believe investor positioning may reinforce any downside trigger. “Fast money” investors such as CTAs, macro hedge funds and long/short equity funds saw their beta to global equities come down significantly over October, which was one factor behind the rout. Many of these investors now seem to have sufficiently reduced their equity exposures, as their betas have either stabilised or turned negative. On the other hand, “real money” investors, such as households, pension funds, mutual funds and foreign investors, still look to be significantly long equities. For example, according to the Fed’s Flow of Funds, as of Q2 2018, about 44% of the assets of real money investors were in equities, a level not seen since 2000. More timely data on equity fund flows suggests this is still the case, as flows look to have declined only modestly during the October sell-off. Combined, these investors are also the major holders of corporate equities, owning about 84% of the market as of Q2 2018.
Protecting the downside at the cost of the upside
Given this backdrop, bonds should be the first place to reduce risk. But, as we saw in October, they may not provide their usual protection. As an example, the Barclays Global Aggregate Bond Index was down 7bps on average when the MSCI ACWI was up, but only rose 2bps on average when the MSCI ACWI was down. When hedges become less efficient, it is critical to deleverage and identify other potential hedges. We believe our alternative risk premia will play an important role in this context, but we are also looking for optional exposures when pricing is attractive and for high-conviction relative value trades to diversify away from market beta. And while our long USD exposure has been a beneficial hedge, we do not believe it will be as defensive as it has been. Of course, if our central scenario is wrong and investors shift to a risk-on sentiment, we will participate less than usual to the upside. But, given the number and nature of the risks, we believe it is more prudent to protect the portfolio than to try and time a market rally.