Taking further risk off the table makes little sense given recent supportive economic data with GAM Investments’ Larry Hatheway urging investors to remain patient despite the current backdrop of geopolitical uncertainties.
The GAM chief economist said investor conviction faded during the second quarter of the year leading to “directionless markets accompanied by bouts of volatility”.
Global government bonds yields also fell recently having hit cyclical peaks in May leading to some flattening of the yield curve as investors reduced allocations to risk assets.
Year-on-year nominal US Treasury yield curve
Source: US Department of the Treasury
As a bellwether for the health of the economy, fund managers and economists have continued to keep an eye on the US Treasury yield curve for signs of inversion, a predictor of recession.
The GAM chief economist said flattened yield curves had contributed to renewed weakness in value investing more recently, while the reversal of some consensus positions such as long equities, long emerging market equities and short duration also eroded risk appetite.
“The reversal of many popular pro-cyclical trades contributed to poor performance among many active managers, further undermining investor confidence,” he said.
Investor risk appetite abated as concerns over an escalating trade war took hold of markets during the second quarter after US president Donald Trump imposed tariffs on several countries, including close allies.
Canada, Mexico and the EU were hit with tariffs as Trump claimed ‘national security’ issues over cheap imports of steel and aluminium.
However, the countries retaliated with their own tariffs on a range of American-made products prompting concerns over further escalation.
A more hardened stance from China over trade negotiations with the US also fuelled worries that trade disputes could intensify and begin to have a significant impact on the wider global economy.
“From a sector perspective consumer discretionary, luxury and auto sectors were among the hardest hit by trade war fears, as were trade-exposed segments of emerging markets,” said Hatheway.
“In short, investor confidence has been sapped by a sharp turn from US business-friendly policies in 2017 – tax cuts, deregulation – to a populist anti-trade fusillade of 2018 that appears unlikely to abate before the US mid-term elections in early November,” the GAM chief economist said.
While investor sentiment has turned somewhat more recently, Hatheway said markets “avoided an outright freefall” during the second quarter because global growth remains resilient and economic data bodes well for the Q2 earnings season.
In terms of asset allocation, Hatheway said having reduced equity exposure during the first quarter of the year, it would be unwise for the firm to reduce risk further, notwithstanding a significant geopolitical or growth shock.
“Corporate profits remain well supported by global growth and cost discipline,” said the GAM chief economist. “Wage growth, in particular, remains subdued, even where full employment has been achieved.
“Investors are likely to reward companies with demonstrated revenue growth, for instance in quality styles and information technology.”
However, the firm is taking a more selective approach to where it invests noting challenges in several areas.
“We remain cautious on Europe and emerging markets, despite more attractive valuations,” said Hatheway. “Europe may yet deliver better earnings growth, but its inability to do so in a broad and consistent fashion thus far in the cycle suggests that investors will remain sceptical until the earnings recovery is plainly evident.
“A sustained reversal of US dollar strength is probably necessary to boost sentiment toward emerging markets.”
Performance of EM currencies vs US dollar YTD
Source: FE Analytics
As the above chart shows the US dollar has made significant gains against emerging market currencies – represented by the Brazilian real, Indian rupee and Chinese yuan – in 2018, so far.
The dollar has been supported by strong economic growth for the US economy compared with other developed markets.
However, emerging economies have struggled to adapt to the strengthening dollar, placing pressure on an increasingly indebted corporate sector. Indeed, the amount owed by emerging markets non-financial corporates rose to $31.5trn at the end of the first quarter, according to data from the Institute for International Finance compared with a $27.5trn a year earlier.
One area that the asset manager’s asset allocation team is continuing to back is short-duration debt, particularly in global government bonds and speciality credit – such as mortgage-backed securities and floating rate notes – where volatility is typically lower.
“The Fed is likely to hike rates twice this year and three times in 2019, given the restoration in the US of full employment, continued above-trend growth and the attainment of its mandated rate for core inflation,” said Hatheway.
FOMC participants’ assessments of appropriate monetary policy – ‘Fed Dot Plot’
Source: Federal Reserve
“Notwithstanding ‘dovish tapering’ rhetoric from the European Central Bank, its normalisation of policy is also likely to continue this year and next. Finally, some adjustment of the Bank of Japan’s yield curve target remains possible before year-end.”
Ultimately, however, GAM’s Hatheway said people need to take a longer-term view and ignore the noise that came to dominate markets during the second quarter of the year.
“Overall, we feel investors ought to be patient and ‘ride out’ current market conditions,” he said. “Selective risk allocation to equities and short-duration credit with an emphasis on low correlation and capital preservation, accompanied by a flexible tactical asset allocation, remains our preferred multi-asset approach for the second half of 2018.”