Going into the fourth quarter, the Asset Allocation Committee (AAC, “the Committee”) reflects upon how unusual 2018 has been for financial markets. One of its most notable features has been some extreme divergences between asset classes that have usually exhibited high correlation. Consider the huge performance gaps between U.S. and emerging markets, for example, or between growth and value stocks. At the latest AAC meeting, debate focused on whether these are significant relative value opportunities. If the business cycle can extend through 2019 and becomes the longest of the modern age, they probably are. But does recent volatility suggest they might really be a sign of how brittle that cycle has become?
By the end of August 2018, the S&P 500 Index was up 9.94% for the year while the MSCI Emerging Markets Index was down 6.99%—a difference of almost 17 percentage points. Within the U.S., the Russell 1000 Growth Index had outperformed the Russell 1000 Value Index by 12.73 percentage points. Similar divergences have opened up within most asset classes. U.S. high yield was up 2% by the end of August, for example, but emerging markets local currency bonds, whose issuers enjoy a better average credit rating, were down 10.47%.
While notable, these divergences can be explained by underlying fundamentals. Economic data out of the U.S. has been robust. Similar data out of Europe and the emerging world has softened. That and the boost to U.S. business from domestic tax policy have fuelled expectations for higher U.S. interest rates and a stronger dollar. A strong dollar raises concerns about emerging markets, as does the discordant mood music on global trade. And when it comes to value versus growth, while value stocks have tended to outperform late in the cycle, this is an unusual late-cycle environment: low growth, low inflation and subdued business confidence at the global level has sustained demand for U.S. growth stocks.
Divergences like these could be significant relative value opportunities. In the AAC’s central scenario, in which U.S. data moderates and the rest of the world stabilizes, these markets are likely to re-converge to the mean. The business cycle could then extend to become the longest on record. There are risks, however. Some of these relate to short-term shocks that could result in another leg wider in these divergences: a market-unfriendly election result in Brazil, further heated debate within the European Union over the sustainability of Italy’s budget, a surprise result in the U.S. mid-terms, a hard Brexit. These would likely delay but not derail market convergence.
A more profound, fatal blow could be struck to the business cycle should we see a continuation of the economic dynamics that caused this year’s market divergences. Stresses and strains such as these appear to be behind the most recent bout of volatility to strike bond and equity markets. A world in which the U.S. continues to power forward in isolation is one in which the Federal Reserve is forced to move aggressively before the European Central Bank (ECB) or the Bank of Japan (BoJ) are ready to normalize their own policies. In that world, the dollar could soar, which would likely cause financial conditions to tighten sharply and crush the cycle.
A Closer Look at Emerging Markets
Emerging markets would likely fare worst in those conditions, and this year’s sell-off across debt, equities and local currencies had the feel of late-cycle tremors. For that reason, they were the focus of the Committee’s discussions, and where we tested our core views most rigorously.
The AAC suspects that emerging markets are pricing dollar and U.S. interest rate risk cautiously, because the perceived links are a widely accepted consensus. In fact, among bearish periods in emerging markets since the 1980s, only the 1982 Latin American crisis and the 1994 Mexican “Tequila Crisis” were connected to rising U.S. rates. On the four other occasions when the Fed was hiking, emerging markets rallied.
By contrast, emerging market credit spreads and company earnings have shown strong correlation with trade volumes and China’s money and credit supply. The longer-term robustness of emerging markets likely turns more on the path of the U.S.-China trade confrontation, and the willingness and capacity of China to apply economic and monetary stimulus, than on the Fed or the dollar. These risks may not be so fully priced.
We address the trade question in our “Up for Debate” section. The more important risk, in our view, is that China feels unable to apply a substantial stimulus in the event of a downturn, as it seeks to avoid the credit excesses of the 2009 – 10 and 2015 – 16 stimulus programs.
While China’s money and credit growth is indeed still contracting, the authorities have already stopped tightening policy. Market participants expect them to act more aggressively should they need to. Our view is that China will likely act to maintain its domestic growth targets and that, for all the risks of storing up problems for a future date, this will be sufficient to lay the foundations for the last leg of the expansion. Nonetheless, uncertainty is likely to persist for some weeks.
As such, the Committee maintained its overweight view in emerging market equities, with an eye on relative valuations after this year’s sell-off, and also kept its overweight view on emerging markets debt, where there was agreement that Argentina and Turkey are apt for deep-value hunting. However, we also maintained a preference for short-duration, hard-currency sovereigns for their attractive yield and moderate risk exposure, acknowledging the risk of another leg down.
Pro-Cyclical or Defensive in the U.S.?
While the AAC’s final decision was to remain neutral on size and style in U.S. equities, in its discussion there was a slight preference for smaller and more value-oriented companies. The risks to that view include the possibility that the Federal Reserve is forced to tighten quickly to contain inflation (see “Up for Debate: V-Shaped or U-Shaped—How Might this Cycle End?”), as well as uncertainties arising from the U.S. mid-term elections.
The most likely outcome, and the current market expectation, is for the Democrats to re-take the House of Representatives and the Republicans to hold the Senate. Should the Democrats secure both houses of Congress, uncertainty rises substantially. A number of outcomes are possible that could curtail the cycle—by depressing confidence, super-charging inflation or both. This is why the AAC remains size- and style-neutral in the U.S. for now.
Expectations for Europe and Japan
After moving from an underweight to a neutral view on non-U.S. developed market equities last quarter, we maintained that view—although there was some debate about pushing to an overweight view, due to relative valuations. We maintained our underweight view in non-U.S. developed market debt, however.
In Europe, core sovereign nominal bonds still look expensive and Italy’s government has adopted a defiant stance on its budget, although we are more encouraged by the ECB’s forward guidance on maintaining negative interest rates well into 2019. In Japan, bonds remain expensive, but equities could benefit from the increasing traction of Abenomics and the weak yen. Both regions are highly exposed to the risk of a worsening trade war between the U.S. and China, and to China’s economic slowdown.
Alternatives to Traditional Market Exposure
With so many variables in balance, the AAC’s view on overall risk-asset exposure has not changed substantially from the cautiousness of our recent Outlooks.
We still believe there is a place for strategies that provide the potential for market-like returns with lower volatility or non-traditional market exposure. We view absolute return strategies and lower-volatility strategies such as collateralized index put option writing as useful in this environment. In private equity, current deals have worryingly high valuations and very aggressive capital structures, and ultimately we think the ideal time to invest would be at the peak of this cycle and on into the other side. Nonetheless, for its higher return potential over listed equity and the lower volatility profile it brings to an investor’s balance sheet, we still consider private assets appropriate for a portion of a balanced portfolio.
A Critical Point
We feel that, if the economy gets through the coming weeks without being derailed by Brazil, Italy, the U.S. mid-terms, Brexit, a trade war, rising U.S. inflation, or a failure of China to stimulate or of Europe and Japan to regain their growth impetus, that would bode well for a continuation of the business cycle through 2019 and 2020. That reads like a long list of risks, but many are interconnected and we regard all of them as containable. When the picture does clear, if things look positive the rebound in sentiment could be sharp—particularly in emerging markets, which have tended to rally strongly after large sell-offs in the past.
Some of the fog could persist into the new year. Realistically, however, investors should be ready to make up their minds on the robustness of the cycle by around the time of the U.S. mid-terms in November. It remains to be seen whether the AAC’s views will reflect a desire to seek more shelter from low-volatility, less market-sensitive allocations, or to press home our exposure to a newly robust global growth outlook. Either way, this feels like a critical point in the cycle, and our next AAC report may well reflect a broader and more decisive shift in our asset-allocation views.