Strategy & economics
December turmoil: what’s spooking global markets?
Equity markets worldwide are reacting to fears of a slowing global economy. But have they got ahead of themselves?
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.
Chief Investment Officer
Caspar Rock joined Cazenove Capital in September 2016 and is Chief Investment Officer. He joined from Architas Multi-Manager Ltd, a part of the AXA group, where he was Chief Investment Officer and responsible for all aspects of the investment activities, including investment philosophy, process and team. He also oversaw portfolio management at two of AXA group’s private banks. He previously headed up the multi-manager business at AXA Framlington from 2006 to 2008. Prior to that, he managed a range of directly invested equity and bond portfolios, and was Head of European Equities at Framlington as well as a member of the Healthcare team. He has 29 years’ investment experience.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
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This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.