Last quarter, we anticipated mean reversion after the December sell-off, and for three months markets have delivered it with confidence and momentum. There has been no real improvement in fundamental economic data, however, and releases in China and Europe have worsened. The turn in sentiment is mostly due to the dovish stances adopted by the Federal Reserve and European Central Bank. In our view, U.S. risk-asset pricing is now back in line with and perhaps even slightly ahead of our expectations for a soft landing and an extension to the cycle, while value remains available in other markets. But volatility is likely to persist until better data out of China and Europe puts firmer foundations under the market’s change of mood.
The market views we articulated three months ago were contrarian. Considering that we expanded our existing risk-asset overweights in emerging markets and U.S. large-cap equities to include U.S. small-company stocks, Japanese equities, broad credit and commodities, some would have said they were heroic. Today, with global equities having clawed back two-thirds of their Q4 losses, high yield bond spreads 150 basis points tighter and oil up by some 30%, we are back in the mainstream.
Underneath it all, the Asset Allocation Committee’s (“AAC” or “the Committee”) fundamental expectations for the economy remain unchanged. We anticipate a freeze on interest rate hikes from the Federal Reserve to provide the cushion for a U.S. soft landing. We believe that monetary and fiscal stimulus should arrest China’s downturn and deliver a boost to Europe, Japan and the emerging world. And we think the resulting convergence of global growth rates can help the current business cycle extend into 2020 to become the longest on record.
A Dovish Turn
While market sentiment has realigned with these views, and in some cases even run slightly ahead of them, economic data have yet to catch up.
U.S. numbers remain stable: Q4 GDP provided an upside surprise, wage inflation is picking up steam, consumer confidence and corporate capital expenditure intentions appear robust and Purchasing Managers’ Indices (PMI) have settled at quite high, expansionary levels. Poor retail sales during the holiday season and weak payrolls in February give pause, but on the whole the U.S. feels solid.
Elsewhere, if anything, the news has worsened since the New Year. Manufacturing sectors in Europe and Japan have shown further signs of stress and fatigue as the engine of the global economy, China, continues its steep slowdown. Here, industrial output is sluggish and unemployment is rising. An uptick in fixed-asset and property investing and signs of credit expansion are encouraging, but that amounts to far less than a recovery.
If sentiment has improved, then, it is not due to confirmation of an economic stabilization and recovery, but to a dovish turn from the Federal Reserve in January and the European Central Bank (ECB) in March.
At its most recent meeting the Fed confirmed that rates were very unlikely to rise in 2019, and that its balance sheet run-off would be done by September rather than stretching into December. But the message had already been sent in January, when the normally hawkish Boston Fed President Eric Rosengren pointed to China’s economy, tensions over trade and “heightened volatility” as reasons to remain “flexible and patient” with policy, and Vice Chair Richard Clarida hinted that the central bank’s balance sheet policy could change if necessary. It was Jerome Powell himself who helped spark the New Year risk rally with his remark that “we’re listening with sensitivity to the message that markets are sending.” Given the steady hum from the U.S. economy and the fact that inflation is on target, many took this to be akin to a “Powell Put.”
In the euro zone, the sluggish economy, struggling banks and negative rates already had commentators using the 20th anniversary of the Bank of Japan’s zero interest rate policy to muse on the “Japanification” of Europe. The ECB’s surprise early announcement of a third program of Targeted Long-Term Refinancing Operations (“TLTRO 3”), and an extension to its forward guidance on rates, added to the theme in March. The initial market response was more muted than that which met the Fed’s earlier adjustments. That was partly because the announcement came alongside severe cuts to the ECB’s near-term growth and inflation forecasts, partly because there was initially no discussion about the difficulties banks have with negative rates, and partly because it was unclear whether the terms of TLTRO 3 would be economical for the banks that need it. Nonetheless, ultimately the move is likely to be seen as adding to the accommodative environment.
Risks Remain Live
As a result, having implemented overweight views in investment grade bonds, U.S. equities and commodities in December to take advantage of what we saw as an attractive value opportunity, we have now nudged back to neutral. The market rally and downward revisions to 2019 earnings estimates have helped U.S. equities return to what we consider full valuation, and fixed income markets are now pricing in a long period of frozen rates.
Indeed, the AAC questioned how sustainable the current upward momentum is. We would not be surprised to encounter more volatility in the near term, as investors see those lower earnings estimates become hard reality during the second quarter, just as they are looking for further confirmation of a bottoming-out in the global slowdown and getting to grips with the special challenges of late-cycle positioning. It is for these reasons that the AAC maintained its overweight views in hedge fund strategies, which offer the potential both to mitigate and take advantage of volatility. We also stand ready to respond to volatility with additional tactical allocations to risk assets, just as we did back in December.
We do remain overweight non-U.S. equity markets and underweight non-U.S. investment grade bonds, however. Risk assets in these parts of the world not only started from a lower base at the start of the year, but also lagged on the way back up. Given our fundamental soft-landing and global-convergence expectations, we still see value there. Looser policy and a weakness in both the U.S. dollar and euro would reinforce that value (see “Up for Debate: Is the Dollar Rally Done?”), and both the emerging world and Europe would be highly geared to any recovery in China, trade confidence and global economic activity.
The signals remain mixed, however. Consider Europe, for example. From the bottom up, some of our equity analysts and portfolio managers report talk of “green shoots” in Europe from company management on both sides of the Atlantic. With the exception of a few days’ disappointment at some of the details of the ECB’s recent announcements, bank stocks have led the market recovery. That indicates growing confidence in the underlying economy. On the other hand, the German yield curve has again flattened substantially, dipping below zero as far out as nine years. That indicates quite the opposite.
Those mixed signals reflect the fact that the risks to our soft-landing and global-convergence thesis remain live. Those risks include the potential for further dollar strength; the potential failure of U.S. – China or U.S. – Europe trade talks, and the possibility that the auto sector gets dragged into the disputes; and the potential for further disappointment from China’s economy.
Progress on containing the dollar and improving the data in China really needs to be evident by the next time the AAC meets in June (see “Up for Debate: Will China’s Stimulus Gain Traction?”).
Before that, we should get a sense of how successful the U.S. – China negotiations have been. While an agreement has been pushed back from the end of March, it does appear likely that one will be reached eventually. Now the U.S. has signaled that raising tariffs from 10% to 25% is off the table, we think it would be very difficult, politically—both domestically and internationally—to put it back on again. The result is therefore likely to be a transactional agreement for China to buy more U.S. natural gas, soybeans and other products, perhaps with a cosmetic agreement around the bilateral trade balance and currency and some modest progress on intellectual property protections, but little or no progress on structural change to China’s economic model. That will not eliminate all uncertainty for multinational companies doing business in or with China, but it will likely be enough for both sides to declare satisfaction, and to remove the most disruptive tail risk from the global economy and markets.
To summarize, the first quarter of 2019 has delivered the first important step toward substantiating our soft-landing thesis: looser financial conditions due to stronger markets and the accommodative turn from the Fed and the ECB. We remain cautious in our positioning views as we look for another step on trade over the coming days and weeks; and the final steps on economic stabilization in China and Europe over the coming three to six months.
Markets are currently soaring on the wings of a central-bank dove—but that dove still flies through strong headwinds over rough seas, with the land still obscured by fog.