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We came almost exclusively out of equities across our discretionary portfolios in June and sat on the side lines for a lot of July as the S&P 500 hit new highs. We believed that the market was stretched from a valuations perspective and the risk/reward balance was not in our favour. We added a few positions into our thematic plays but stayed out of the Beta game.
We saw the S&P 500 push higher +1.7 per cent in July but the index struggled to break through and stay above the 3,000 level. Given our absolute return focus equity exposure would have created additional portfolio volatility without lifting returns. With US vs China and UK vs the EU we anticipate bouts of elevated volatility in H2 2019 – which will require nimble movement in and out of equity markets to avoid losses. On the earnings side we have seen earnings per share (EPS) estimates trading down across the world – the UK is the only developed market showing positive EPS revisions – although that will be likely currency related. Despite earnings season in the US showing a surprise of circa 5.5 per cent this was on the back of reduced expectations and we are already starting to see 2020 earnings revised downwards.
We are re-entering a global easing cycle. The market is expecting cuts from the Federal Reserve (FED) and the European Central Bank (ECB) pre year end and our concern, even with the impact of growing dispute between the US and China, is inflation as we move through 2020. Our base case scenario is that the Fed could confirm it will be on an easing bias given the latest developments – in other words give comfort to the market that this “mid-cycle” cut is now an easing cycle. Under this scenario, we expect a short-term bounce in equities and yields to widen a bit from current levels.
Within fixed income, ahead of the Fed meeting on 31 July, we had maintained a neutral duration stance on our fixed income portfolios on the back of our expectations that the market had overdone expectations of multiple interest-rate cuts by the Fed for the rest of 2019. The Fed provided a 25bps “insurance cut” citing downside risks to global growth and trade tensions on multiple occasions as justification and iterated that this is a mid-cycle adjustment rather than the start of an easing cycle. Our analysis of the US economy indicates that there was no need for such a cut and this remains our view (supported by two FOMC dissenters who openly published their conviction of the strength of the US economy).
The second half of 2019 is going to require nimble movement in and out of equity markets.
However, the escalation of the trade war the following day by the US raising tariffs starting at 10 per cent on USD 300bn of Chinese goods due to start in 01 September caused the market to price in even more rate cuts for 2019 and move yields lower. With the latest round of tariffs more likely to provide an inflationary pressure (due to the consumer goods on the list), the Fed will be balancing the potential inflation uptick due to tariffs with the expected weaker growth. As such with yields on the 10 year now at 1.75 per cent, we have actively looked to scale into a short duration position on the premise that the Fed will want to see the conflict between these inflationary pressures and weaker growth play out in the form of data points and more importantly look to assert their independence else being seen as Pavlov’s dog reacting to US President Trump’s trade policy.
In Europe, our short duration stance is further reinforced by the yields on offer in the European government bond market where we now have Switzerland 30 year paper negative yielding (entire swiss curve) and only see periphery eurozone 10 year paper like Spain, Bulgaria, Portugal, Greece and Italy offering positive yield. As such, within this asset class, we are holders of Greek and Italian paper whilst the search for yield continues and steadfastly refuse to pay governments for holding their paper.
In Credit, we switched in the US from high yield to investment grade paper and whilst IG has now become “fair value” according to our models. We are maintaining this stance waiting for a widening of HY spreads to provide an opportunity to enter the market – where the weakness in equity markets is now moving spreads to a fairer level.
In currencies, UK Prime Minister Boris Johnson’s threat of a no-deal Brexit has helped push GBPUSD sub 1.22 and the Fed’s cut being slightly smaller than anticipated saw USD strengthen versus the EUR down to the 1.1050 level but has still not broken through the 1.10 line in the sand. Gold remains a fear trade on the back of concerns over a trade war and Brexit fallout but looks stretched from a price perspective.
Our monthly breakfast briefing is an opportunity to better understand how recent economic and political developments are likely to affect financial markets. Watch members of our investment team present some of our latest investment ideas and key themes of the August investment update.