Will Bartleet, CIO and Portfolio Manager of Pacific Multi-Asset
Market commentary, portfolio positioning and outlook
After nearly a decade of a mostly uninterrupted rise in equity markets, the final months of 2018 saw a sharp pick up in volatility and a decline in stock markets around the world. Headwinds for the markets have been building over the last few months: central banks have persisted with interest rate increases and ended their QE programmes, uncertainty surrounding Brexit has continued, the trade war between the US and China has intensified and global growth has slowed.
In December, the US Federal Reserve raised interest rates for the fourth time in 2018 and disappointed equity investors by indicating that they expect to continue to tighten monetary policy in 2019 by a further two hikes, despite signs that US growth is slowing. This led to a scathing attack on Chair Powell by President Trump who tweeted that “The only problem our economy has is the Fed.” News of a thawing of relations between the US and China at the G20 meeting in Argentina were quickly replaced by a new crisis over the arrest of the CFO and daughter of the founder of Huawei, one of China’s largest technology companies.
The year-end “Santa rally” was conspicuous by its absence, with all major equity markets falling in December. The US stock market, which had been insulated from the falls over the summer was brought back to earth as the combination of high valuations and slowing growth weighed heavily on American equities. UK and Emerging Markets equities were not immune to the falls, but their lower valuations meant that they were somewhat insulated from the downturn, falling less than half that of the US market.
Bonds were a source of diversification in December, with government, investment grade and Emerging Market debt rising over the month. These benefited from expectations that central banks, in particular the Federal Reserve, will be unable to raise rates much further in the face of slowing growth.
Within our multi-asset portfolios, we have been steadily reducing equity risk, so we entered this volatile period defensively positioned with a lower than typical allocation to stocks. The equity allocation is tilted towards the cheapest areas of the stock market, which are often less susceptible to a fall in markets and have the potential to rise faster as the market recovers. This leads us away from the US stock market which is the most expensive large stock market in the world and where we see the prospect of lower future returns than the rest of the world.
Away from equities, our bond exposure is highly diversified, comprising of government bonds (for lower risk portfolios), corporate bonds, high yield and emerging market government bonds. Fixed income covers a huge spectrum of assets from incredibly steady to higher risk/reward opportunities. Whilst developed government bond yields are low relative to history, they still have a place in lower risk portfolios as diversifiers in an equity market fall triggered by slowing growth, whilst some other areas of the bond market offer the potential for attractive returns and diversification benefits.
All our multi-asset portfolios have an allocation to Diversifying Strategies which are uncorrelated to both equities and bonds. The allocation to Macro strategies generated strong returns during December when equity markets struggled. We think the environment looks increasingly attractive for these strategies as central banks adjust their interest rate policies in the face of a changing economic outlook.
Within Alternatives, in December we made an allocation to a gold ETF which acts as a useful diversifier and has tended to generate strong returns when interest rates are low after adjusting for inflation. If the Federal Reserve is forced to pause its rate hiking cycle, we expect gold to perform strongly and, in the meantime, gold offers useful diversification benefits in the face of the uncertainty surrounding Brexit.
Finally, we are tactically holding a significant holding in cash and short dated investment grade bonds. Whilst cash is a poor long-term investment with UK interest rates running below inflation, holding dry powder allows us to take advantage of opportunities which will inevitably be thrown up by market volatility.
We outlined a number of headwinds that have been building for markets over the last few months that have led to a pickup in volatility in markets. Whilst volatility is uncomfortable, it’s worth remembering that it is also normal. Equity markets have been abnormally calm for many years, so it’s completely natural for there to be bouts of volatility. Volatility provides opportunity; often markets overshoot both to the upside and to the downside in a volatile environment, providing opportunities to buy cheap assets. Whilst we are currently defensively positioned, we think that it’s likely that the issues that have been confronting markets will be at least partially resolved over the coming months as central banks pause their interest rate hiking, the US and China come to an agreement on trade terms and there is more clarity over Brexit.
Markets hate uncertainty, so any resolution of these issues would be a positive for the stock market. We hope to take advantage of the volatility in the meantime to use our dry powder to buy attractively valued assets.
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