The contrast between the first quarter of 2019 and the final quarter of 2018 could not be starker. The speedy shift in market sentiment from gloominess to cheerfulness around US Federal Reserve policy and the US-China trade dispute has lifted all boats. As we look forward to Q2, we caution that the same fundamental issues around slowing economic growth remain, although this is more a return to trend late-cycle conditions rather than a recession. Still, in the short term, excitable markets may have got ahead of themselves resulting in a disconnect between fundamentals and price performance, and investors adopting an indiscriminate risk-on approach could be exposed to swings in sentiment.
Eighteen months ago, in our Q4 2017 Outlook, we suggested the bull market was still intact but entering its last phase and we advocated a Braver for longer approach. Since then, the cycle has ground onwards with two periods of correction and the bull market continues. There are risks aplenty, but there are also attractive opportunities if you look hard enough - there is still some life left in this old cycle yet.
Greater clarity on the economic cycle will only emerge towards the middle of the year, but in the meantime the overall picture suggests the global industrial slowdown is continuing. As a result, markets are back into a ‘bad is good’ mindset. Investors should consider a defensive approach to navigate markets where conventional interpretations of data may not necessarily have the expected impact.
Asset class snapshot
While corporate earnings growth forecasts remain too optimistic, our analysts continue to find opportunities on a regional and sectoral level. Japan has been sold off aggressively with much of the bad news priced in. Similarly, investors seem overly pessimistic towards cyclical stocks with Chinese exposure.
With US yields at around 2.5 per cent, and the market pricing in some chance of cuts this year, US treasuries have limited room to rally further. We favour a tactical short position, expecting US rates catch up to the equity bounce. Investors should be cautious of risks around a still unresolved trade dispute between the US and China, and late cycle dynamics.
Given the heightened volatility in markets and the uncertain direction of the global economy, we believe that now is the time to be active in every sense of the word. We are overweight equities but are highly selective in regional allocations given discrepancies in attractiveness. We prefer value stocks in the US, defensive assets like US treasuries and are biased to high quality in credit.
New capital deployment faces style-drift risks. It will be vital to recognise unintended strategy drifts early enough to adjust course and, therefore, to avoid an escalation of risk as the European real estate investment cycle unwinds. Specific to the UK, valuation markdowns in the retail sector were the main reason behind weak MSCI UK All Property performance in 2018, and with further corrections expected, we expect UK-focused funds with the lowest retail allocations to continue outperforming.
"The disconnect between economic fundamentals and markets is unlikely to be sustainable in the short term. Markets are poised for big swings in risk sentiment over coming weeks and possibly months.” - Anna Stupnytska, Head of Global Macro and Investment Strategy