Investors need to ensure they have “robust” portfolio diversification in place for the coming 12 months, according to The Adviser Centre, although there are still opportunities to make money – especially in unloved areas.
Last year saw most parts of the market hand negative or flat returns to investors thanks to a combination of tighter monetary policy from the Federal Reserve, the US-China trade dispute, slowing economic growth, high valuations and uncertainties around Brexit.
Peter Toogood, chief investment officer at The Adviser Centre, noted that he had spent much of 2018 being highly sceptical about the likely path of long-term returns for risk assets. He said that the “giddy mix” of high momentum, unappealing valuations and investors being very long of risk assets created a difficult backdrop.
Performance of indices in 2018
Source: FE Analytics
Going into the year, Toogood had questions over the likelihood that the momentum of the global economy and risk assets would be maintained, as well as over the consensus belief that inflation had return in force and that bonds were therefore a ‘bad’ investment idea.
“Plotting the exact path to the downfall of equity markets was never going to be simple,” he said. “We did identify correctly that the move by central bankers from ‘lender of last resort’ to ‘buyer of last resort’ had artificially distorted both economic growth and asset prices.
“With this in mind, as central bankers gradually withdrew ‘emergency measures’, we expected much greater volatility in asset prices, with the frothiest areas such as technology likely to suffer disproportionately.”
Toogood explained: “We assumed that US equities, despite being more expensive, were the best of a bad bunch, but were overly optimistic that the UK might plot a path out of Brexit; shortly, we will all know if this call was early, or just wrong.”
For Toogood, the final quarter of 2018 – when equity markets suffered their second sell-off of the year – showed by over-confidence, high momentum and elevated portfolio exposures to risk assets can be a “painful experience” for investors.
However, the chief investment officer added that investors start 2019 in a very different place to where they were at 2018’s beginning. One example of this is that expectations for equity markets relatively subdued when compared to the usual positivity seen at the start of a new year, while volatility has moved up from the unusually subdued levels of 2017.
“The stark reality is that the great central banking QE experiment is going into sharp reverse and there are inevitable consequences for asset prices, real or imagined,” he continued.
“Most of the fund managers with whom we have regular contact have been acutely aware of the need to insulate their portfolios from the effects of higher funding costs. Bond managers have moved up the credit quality curve, while equity managers have been overtly favouring less-levered companies.”
Calendar year performance of VIX over 15yrs
Source: FE Analytics
It remains to be seen how the withdrawal of liquidity from global markets will affect risk assets in 2019. The last significant correction was the taper tantrum of 2015 but conditions then were different to today – the Fed was still pumping money into the system and equity valuations were more compelling – leading to an extension of the bull run. “None of this applies today,” Toogood added.
However, he pointed out that global authorities have started to react to the fact that economic momentum has seemingly peaked. China is deploying £1trn of stimulus measures while the Bank of Japan remains accommodative.
The “big daddy” is the US Federal Reserve and Toogood said there is a degree of ambiguity about its next steps. He said that the actions of the US central bank in 2019 “will likely be the trigger for a further rally in risk assets into 2020”.
“A noisy year beckons. Investor expectations are more subdued and earnings expectations are declining. US equity valuations still reflect lofty return expectations, while the rest of the world offers relatively attractive opportunities,” he concluded.
“However, this must be set against early signs of recessionary forces that are now emerging. We continue to recommend robust portfolio diversification, as policy-dependent outcomes are the order of the day.”
Against this environment, Toogood said The Adviser Centre was correct in being cynical in its view of the growth momentum story in 2018 although the heavy price falls of the year mean that a near-term relief rally is likely.
He added that the sustainability of any rally will be highly dependent on both the Federal Reserve softening its policy stance and a sensible resolution to the trade talks between the US and China.
“In terms of what is likely to lead the market higher, we would favour value over growth styles in 2019,” he said. “The momentum in the growth names has been broken and additional sellers are likely to emerge as the ‘FAANG’ share prices recover. Equally, unloved stocks, particularly in the more economically-sensitive sectors, are likely to emerge as the winners.”
When it comes to fixed income, Toogood said 2018 was a “vivid reminder of the importance of holding bonds of all varieties” – but the merits of government bonds and higher quality corporate credit in the face of greater economic and market uncertainty stood out.
“Those of us of a certain age remember how often the Japanese authorities, and indeed investors, believed they had reached economic ‘escape velocity’, only to be bitterly disappointed and revert to their love affair with bonds,” he said.
“Government bonds will also shine if the Federal Reserve is ploughing on with its tightening, because of the negative impact upon economic growth and risk assets.”
In the commodities space, the chief investment officer expects to “see better times” in 2019 if the US dollar weakens as he expects. Furthermore, gold will have a place in portfolios if the Fed keeps tightening policy and inflation becomes more of an issue.