Risk assets surged in January, following the big sell-off at the end of 2018. The MSCI All-Country World Index rose 7.1% on the month and recouped most of its losses from December. The main catalysts behind the strong rebound were (1) a surprising dovish shift by the Federal Reserve that emphasized patience with respect to future rate changes (2) progress on U.S. – China trade talks (3) exceptionally strong U.S. labour market data which reduced fears of a near-term recession (4) strong enough corporate earnings. Although economic data remains weak outside the U.S. and is pointing to a deceleration in global growth, the shift in Fed policy and reduction in macro uncertainties is driving the path of risky assets upwards, as we had expected after last month’s selloff. We think that risk assets have more room to go up in the near-term but expect them to reverse course towards the middle/second half of the year.
During the latest Federal Open Market Committee meeting, the Federal Reserve kept rates steady and pivoted toward a more accommodative stance. The Fed removed the language in its statement that said the next move would be a hike. Instead, it noted that given recent global economic and financial developments, it will remain patient as it determines what future moves may be appropriate, effectively allowing the next rate change to be a hike or a cut. This was a strong pivot from its prior communications in December, which included a median Fed Fund rate of 2.875% at the end of 2019 (50 bps higher than current level). The markets and ourselves were surprised by this shift, as we thought that the strong labour market and desire to move rates closer to neutral to provide more ammunition during the next crisis will drive the Fed’s policy decisions. While the Fed effectively caved in to the markets (and arguably to President Trump), it also put itself in a tricky situation going forward. If the U.S. economy continues to grow at a solid rate and macro uncertainties recede, the Fed may have to shift course and start raising rates again. We think this could likely happen in the second half of 2019 and be associated with a decline in risk assets, but at least for the next couple months, risky assets will continue to get a boost from the Fed’s dovish tilt.
U.S. equity markets outperformed developed market counterparts in January, with the S&P 500 up 7.9% compared to 5.6% for the MSCI World ex-USA index. More cyclical sectors that were beaten hard in Q4 outperformed more defensive sectors: industrials, energy and real estate returned ~11% while utilities and healthcare returned 3.6% and 4.9% respectively. Aside from the Fed’s dovish tilt at the latest policy meeting, equities were powered by 2 very strong jobs reports in December and January with total job gains of 526,000 and an improvement in the ISM manufacturing survey. In addition, two-thirds of the S&P 500 companies have reported earnings for Q4, and 60% of them have beat estimates on earnings and 54% on revenues. Overall, S&P 500 companies have reported Earnings Per Share growth of 12.1% YoY and revenue growth of 5.5%. These results have helped quell concerns about a recession, and companies that have beaten expectations have been rewarded with share price gains that are larger than historical trends. In terms of valuations, the S&P 500 is still trading 7.5% off the highs in October, and its forward P/E of 16.1x is around its post-crisis average. As such, we view valuations as fair and switch to beingoverweight U.S. equities. A further rally of 4-5% would probably lead us to take some chips off the table.
In non-U.S. equity markets, the MSCI Europe index rose 6.2% in January, Japanese equities gained 4.9%, and EM equities gained 7.1%. European economic data continues to be weak (Eurozone manufacturing PMI dropped to 50.5 in January from 51.4 in December and Italy’s economy entered a technical recession) which should keep the ECB’s policy more accommodative. European equity P/E ratios remain relatively cheap (forward P/E of 12.9x), but political risks and their high exposure to decelerating global trade will remain an overhang. The lack of a positive catalyst leads us to move to underweight Europe. In Japan, economic forecasts have been cut due to weaker global industrial data which pressure Japanese exports, although domestic demand remains resilient ahead of the October 1 consumption tax hike. Japanese earnings during Q3 have been weaker then expected, but cheap valuations (Topix trading at 12.7x forward P/E, vs. 9-year average of 15x) should cushion the downside and support ourmarketweight Japan. In EM equities, we stay overweight EMgiven attractive valuations (forward P/E of 12.3x) and our expectation for stronger economic growth and reforms. We continue to advocate diversifying across the regions and being slightly underweight Asia vs. the benchmark and overweight Latin America and EMEA.
In credit markets, spreads retraced a good portion of last year’s widening with the riskier segments outperforming. US HY was the top performer (+4.6%), followed by EM sovereigns (4.5%), EM corporates (2.8%), U.S. leveraged loans (2.5%), European HY (+2.2%), US IG (1.6%), and EU IG (1%). US HY was boosted by the recovery in oil prices and wide spreads at the beginning of the year (544 bps) as well as improving technicals. Valuations for US HY remain attractive in our view (spreads/yields of 430 bps/6.9%) and the continued strength in the U.S. economy should keep default rates low for the time being. On the technical side, US HY funds saw inflows of $4.6 bn in January (compared to $9.2 bn of outflows from loan funds), and supply volumes were relatively strong at $13.6 bn with several deals oversubscribed. As such, we remainoverweight US HY (especially vs. loans) and expect outperformance to continue absent any major shocks.
Emerging market fixed income also started the year on a strong note, driven by the weaker dollar and strong fund inflows. EM sovereigns outperformed corporates given their longer duration and higher tilt towards HY, with Venezuela and Argentina leading the way (43.3% and 6.8% respectively). Two of Latin America’s biggest commodity issuers (Vale, Pemex) were downgraded by the rating agencies to BBB-, leaving them on the cusp of high yield and potential forced selling by crossover investors. Nonetheless, EM debt remains in favour with the largest ETFs seeing strong inflows in January and investors snapping up deals in the primary market. We remain overweight EM debt as valuations are still attractive (sovereign spreads are still 90 bps wider then their tights last February). EM local markets also started the year on a very strong note (+5.3% in USD terms), helped by a 3.4% appreciation in EM FX vs. the USD. We expect the weaker dollar to continue to drive inflows into the asset class, which is yielding 6.2%.
US IG spreads tightened a sizable 22 bps in January (to 138 bps), which more than offset the widening in December. Spreads were supported by a pick-up in foreign buying and lower YoY supply (down 12%). These were driven by more favourable hedging costs for foreign investors and lower supply by financials. US IG is now yielding 4% in aggregate and we remain marketweight US IGand see more value in select BBBs. European IG credit spreads tightened 10 bps and also reversed the widening move in December. EUR IG corporate yields remain very low (1.1%) but they offer a similar pickup over government bonds (140 bps) and offer a balanced risk-reward for European investors. EUR HY tightened 60 bps on the month (to 448 bps) but we are concerned that political uncertainty in the UK/Italy and weak economic activity could drive spreads wider and stay underweight EUR HY.
Overall, we think the dovish tilt by the Federal Reserve and progress on U.S.-China trade talks should continue to drive risky assets higher in the near-term. Equities should provide higher returns in 2019, though picking the right regions and quality factors are key. In fixed income we are comfortable taking more credit and duration risk for the time being to boost expected returns and see the most value in EM and US HY. The main risks we are concerned about are a lack of trade agreement with China given disagreement over technology issues, and a Fed that may have to shift course in a few months if the data continues
to be strong. As always, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.