Can the US avoid a hard landing? Do lower valuations mean I should add risk? And how should I position my portfolio for Brexit? These are the three questions that investors need to ask themselves in 2019.
“America First” was the dominant investment theme in 2018 as president Donald Trump cut taxes in the US, supporting corporate earnings and the S&P 500, while taking a more hostile approach to global trade.
Karen Ward, chief market strategist for EMEA at JP Morgan Asset Management, said it was fear about the impact of trade wars, rather than inflation, that derailed the bull run of the past decade.
“The US Federal Reserve has been slowly raising rates and the European Central Bank has ended its policy of quantitative easing,” she explained.
“While this may have reduced the scale of the monetary tailwind, the real policy rate is barely in positive territory in the US and remains deeply negative in Europe. It’s hard to argue people are suddenly being tempted to save rather than spend.”
Instead, Ward pointed to a 10 per cent tariff which is now being applied to $250bn of US imports from China. This tariff looks likely to rise to 25 per cent on 1 March, and the US administration has shown willingness to increase tariffs on all US imports – more than $500bn of goods.
The market strategist said this had led to a drop-off in new Chinese export orders, while business surveys in Europe are just as bad.
“It’s no wonder that – gripped by uncertainty – companies are once again deferring investment,” Ward explained.
She added that while the US economy has not been overly affected so far, with the impact of tax cuts set to fade throughout 2019, slowing global demand will start to bite at the same time as uncertainty begins to weigh on US capital expenditure.
So, will this be enough to prompt an outright recession and a more meaningful bear market?
“It is possible that a vicious cycle takes hold whereby corporates cut back not only on capex [capital expenditure] but also on hiring,” Ward said. “A softening labour market could then slow consumer spending – the bedrock of the US economy. This is clearly not the end result the US administration is hoping for.”
Ward said a gradual rather than dramatic shift in allocation seems most appropriate to help deal with this two-way risk, adding that there are three key questions investors need to ask themselves as 2019 gets underway.
Can the US avoid a hard landing?
The main theme of 2018 was US economic outperformance. Fuelled by broad-based tax cuts, the economy surged and the Federal Reserve was able to begin normalising interest rates, with this yield differential helping to send the dollar higher.
However, Ward said that US outperformance looks set to fade this year.
“The fiscal sugar rush will disappear having contributed roughly one percentage point to annualised growth in the final quarter of 2018,” she explained. “And the trade tensions may return.”
“In response to a more uncertain global outlook, capex intentions and business confidence are rolling over. The fall in the oil price will reduce activity in the energy sector but will also ease inflationary pressure. While bad for the energy sector, the fall in the oil price should help US consumer spending hold up even if employment growth slows.”
Against this backdrop, Ward said it is difficult to see how the Fed could raise rates much further in this cycle, if at all: by year-end US growth looks set to be below 2 per cent.
However, she added that a recession still looks unlikely in the near term.
“The sectors of the economy that are often responsible for contracting activity – housing, durables and investment – are not obviously showing signs of excess,” she continued.
“The risk to this more benign scenario stems from the rise in corporate debt that has accumulated in the last decade. As companies roll this debt on to higher interest rates, there is a risk that this forces deeper cutbacks in hiring and investment. But if the Fed pauses here as we anticipate, then this risk should be mitigated for now.”
Do lower valuations mean you should add risk?
Ward said this is not a binary question and the answer is dependent on each investor’s time horizon and risk tolerance. Lower valuations suggest higher returns in the long term, but valuations are not helpful for determining returns over the next year.
Valuations could still fall further from here, but the main downside risk would be if corporate earnings are materially downgraded, according to Mike Bell, global market strategist at JP Morgan Asset Management.
“There are several two-way risks for markets from here: a trade deal between the US and China could be reached or there could be an escalation and the US and Europe could experience or avoid a recession by the end of 2020,” he said.
Against this uncertain backdrop, Bell shifted his portfolio allocation to a more balanced position at the end of Q3 2018, describing it as more appropriate than had been the case for most of the last nine years.
He added it is still a good idea to avoid making big asset-allocation bets relative to benchmarks in either direction.
“Within equities, there are risks to being overweight small-cap, growth and low-quality stocks,” he continued.
“Within fixed income, longer-term US government bonds could act as a balance to equity exposures but overweights to credit seem risky and credit investors will need to be selective.
“Given some of the risks in parts of the fixed income market, investors may also want to consider alternative, targeted absolute return strategies, with the ability to hedge equity markets without relying solely on fixed income to reduce risk.”
He added that with equities and other risky assets delivering strong gains over the past nine years, his near-term focus is on locking in those returns with a more balanced portfolio.
“While volatility is painful, we know that eventually it creates opportunities. When that time comes it is important to have some dry powder,” he said.
How should UK investors position themselves for Brexit?
Ward said the biggest challenge facing UK investors is the uncertainty caused by the Brexit negotiations, not least because sterling is likely to end 2019 noticeably higher, or lower, than where it is today.
Analysis from the Bank of England shows that a no deal scenario would likely result in a further 15 to 25 per cent decline in sterling, depending on exactly how disorderly the situation becomes.
While this may put upward pressure on those large-cap FTSE stocks with significant overseas earnings, Ward noted that recently, falling sterling has not coincided so clearly with a rising FTSE 100. She said this may reflect both the potential impact of a no-deal scenario on global risk appetite as well as uncertainty about the impact of a potential change in government in the UK.
“There is still a very limited risk of a ‘no deal’ scenario and there is not a majority in parliament in favour of leaving without a deal,” she said.
“The fact the European Court of Justice has ruled the UK can unilaterally revoke Article 50 prevents the scenario of the UK crashing out simply because time has elapsed. Ultimately, we think the risk of a new referendum and staying in the EU causes the Conservative back bench to back the deal as a better-than-nothing route towards Brexit.
“In such a scenario we would expect sterling to rally,” Ward concluded.