Despite a strong start to the year, the volatility witnessed in the final months of 2018 is likely to provide a better longer-term picture of how markets will behave in the months ahead, according to GAM Investments’ Larry Hatheway.
Markets struggled towards the end of last year as investors became increasingly concerned over the Federal Reserve’s pace of rate hiking – and a risk of US recession – as well as developments in the ongoing trade dispute between the US and China.
During the fourth quarter the MSCI AC World index was down by 12.51 per cent, while the S&P 500 dropped by 13.66 per cent, in local currency terms.
However, since the start of the year the global equity index has made a 10.99 per cent total return, while the US benchmark is up by 11.57 per cent, as the chart below shows.
Performance of index YTD
Source: FE Analytics
Markets have been boosted by a pause in the Fed’s drive to normalise interest rates and a truce between the US and China following the postponement of punitive trade tariffs originally due for introduction in March.
“While there is room for the market to run further, we have now recovered much of the ground lost in the fourth quarter of last year,” said GAM group chief economist Hatheway.
“Major indices are back at early Q4 levels and are beginning to look a bit stretched now relative to the weaker global growth backdrop that has also emerged.”
Providing the US and China can find an accord over trade, Hatheway said the strong rally seen since the start of the year will continue.
Not all markets have enjoyed a strong start to the year, however.
The GAM chief economist said fixed income markets have yet to move back to the levels that were prevalent before the turbulence of Q4 2018.
Bonds have struggled, said Hatheway, because investors do not anticipate a further interest rate hike by the Fed in 2019. This could change as confidence returns to markets and the broader economy, putting pressure on the central bank to move rates higher.
“I think it is likely that we will see bond yields moving higher later this year, reflecting unfinished business by the Fed,” said Hatheway.
The greatest opportunities for investors this year will be found in emerging markets, said Hatheway, providing trade and other political risks remain subdued.
Following a strong 2017, the MSCI Emerging Markets index fell by 10.08 per cent in 2018 as concerns over the impact of a trade war between China and the US – and a tougher stance from president Donald Trump – spooked investors.
Performance of index in 2018
Source: FE Analytics
However, the postponement of US tariffs on China has boosted sentiment towards emerging markets and the index has risen by 8.93 per cent.
“They are most exposed to global trade, so a reduction of trade tensions would disproportionately be of benefit to them,” Hatheway explained.
“Also, China is trying to stimulate its economy. Typically, Chinese stimulus spills over positively in emerging markets.”
There could be other beneficiaries as well, according to the GAM chief economist, including Japan and Europe.
Investor sentiment towards both has been muted over the years. While the prognosis for the Japanese economy has strengthened somewhat, Europe remains in the doldrums as it continues to deal with the impact of Brexit and other challenges.
“Although Japan has lagged at the beginning of this year, its market has long-term potential and we believe it will find its footing again,” said Hatheway.
“Europe could also surprise. It is out of favour [and] it is the least loved market among investors. Yet for precisely that reason it has potential to surprise to the upside.
He added: “Weakness in European growth last year was, in part, due to special factors which we believe are likely to recede in importance.
“As those effects fade, growth could pick up more than expected, helping to lift earnings expectations.”
Despite the strong start to markets and the opportunities for risk-on investors, Hatheway said that the turbulence in markets at the end of 2018 was likely “a harbinger of things to come”.
This is a theme that has been identified by fund managers responding to the closely watched Bank of America Merrill Lynch Global Fund Manager Survey, with a net 46 per cent of respondents expecting growth to weaken over the next 12 months. A net 42 per cent expecting global profits to deteriorate, although there was a slight improvement on January’s figure which was the worst profit outlook since December 2008.
Source: BofA Merrill Lynch Global Fund Manager Survey
As such, investors will need to get used to new conditions and change the way they think about risk.
“Against that backdrop, risk matters more than it did when things were improving,” said Hatheway. “Consequently, capital markets will remain vulnerable to jitters about political or policy risk.”
He warned that risk-adjusted returns could be significantly lower in the year to come than those recorded during the past decade. Furthermore, volatility is likely to recur more frequently, while correlations will become less predictable.
Thus, investors will need to ensure they have greater diversification within their portfolios.
“How should investors diversify?” Hatheway asked. “We believe a modest exposure to global equities and fixed income, combined with more significant allocations to non-directional strategies and cash are the building blocks of diversified portfolios.
“In our view, such portfolios ought to be better able to withstand the shocks that will inevitably recur in capital markets in a ‘post-peak’ world.”