We enter a new year with markets carrying a heightened level of uncertainty, primarily driven by fears of slowing economic growth, with the prospect of incremental headwinds from the trade spat between China and the US. The less accommodative monetary policies seen this year have also had a clear impact as the financial system continues to slowly “normalise” from the policies of low or negative interest rates and quantitative easing.
The bond and money markets have previously provided an accurate assessment of future economic conditions. The two indicators we follow closely are the shape of the yield curve and the second is the level of real (after inflation) bond yields. We are currently getting conflicting signals from these two measures. The yield curve is nearer a warning signal for the US economy - it has flattened progressively during the year as short-term interest rates rose and longer maturity bond yields did not rise by as much. Real rates on the other hand are some way from signalling trouble ahead as they are still very low, and only tend to cause problems in the US economy when they are in excess of 2.00% (see graph, below).
It is reasonable to be concerned that the reversal of the various central bank quantitative easing programmes may indicate a tighter liquidity environment that the bond markets are currently suggesting, and this may be manifesting itself in the recent widening of the spreads for investment grade and high yield bonds.
US real Bond yield^ vs shape of the US yield curve*
^US 10 UST yield minus CPI *Term premium as indicated by the difference between the yield from 10-year UST and 2-year UST
Historically, equity markets have started to discount recession in advance of it happening, but at time of writing, it does feel as though the market appears to be somewhat ahead of itself. Two widely followed barometers of sentiment currently reflect this: the Credit Suisse Global Risk Appetite Index, which trades between “euphoria” and “panic”, is currently in panic territory, while the spread between bulls and bears in the survey from the American Association of Individual Investors points to the same conclusion. When this occurs, typically markets recover.
Investors will continue to be concerned about the risk of recession in major economies and increased market volatility is likely. Against this more uncertain backdrop we expect 2019 to be a year of relatively low, albeit still positive equity market returns.
Earnings growth forecasts remain susceptible to downgrades. In the US, 2018 growth was boosted by changes to tax policy. Trade tensions have the potential to be a headwind everywhere but especially for Asia and emerging markets, whilst Brexit uncertainty will continue to weigh on domestically focused UK companies. It is unlikely that corporate profits will fall without a recession and whilst there is the risk of a faster decline in economic activity than expected, we see healthy household balance sheets, a relatively high personal saving rate, strong labour market momentum and high business confidence. We do not expect a global recession in 2019 and retain our neutral equity allocation.
We expect government bonds to benefit from slowing global growth and flows into more defensive assets. We continue to prefer inflation linked government bonds to conventional ones given relative valuations, particularly in the US.
Despite credit having become more attractively valued, it is likely that returns generated from investment grade and high yield credit will be limited in 2019. We remain more positive on emerging market debt, where fundamentals are robust, technical factors are unchallenging and valuations attractive.
As we expect a more challenging market environment in 2019, we see opportunities for absolute return managers to perform. We continue to favour trend following strategies and equity long / short hedge funds with lower correlations to traditional asset classes. Cash may also be used as a defensive asset.