Investors need to get used to the ‘post-peak’ market environment, according to GAM Investments’ Larry Hatheway, with slower US growth and few countries able to take its place as leader of the global economy.
The past few months have been a challenging time for investors as stock markets have experienced significant sell-offs amid concerns over Federal Reserve tightening and more subdued outlook for corporate earnings.
As the below chart shows, the MSCI World has fallen by 6.74 per cent – in sterling terms – during the past three months.
Performance of index over 3mths
Source: FE Analytics
“Investors have opted to de-risk portfolios over the past six weeks, shedding equities and, in particular, the most heavily-owned segments of the global equity market,” said GAM Investments chief economist Hatheway.
“Information technology and quality stocks, alongside major US indices, have led the way lower.”
The allocator noted that some “traditionally higher beta segments” of the market such as emerging market equities had outperformed over the period.
Yet, the overall situation paints a different picture.
He explained: “The implication is clear: investors are de-risking by offloading positions they acquired earlier this year, namely the consensus longs in the market.”
Hatheway said although volatility had largely been contained in global equities, the corresponding moves in government bonds and currencies had been relatively small.
“In other words, investors have de-risked without correspondingly increasing holdings of either ‘safe haven’ or other assets,” he explained.
“Cash is king. Investors know what they want less of but are uncertain about where to reallocate.”
The economist argued that the recent market behaviour suggested a new market paradigm ‘post-peak’, noting that US growth had peaked during the second quarter of the year and is likely to slow going forward.
“Either capacity constraints will gradually apply the brake to growth or the Fed will ensure that outcome by raising rates until activity ebbs,” he said.
“After all, the Fed is witnessing a gradual rise in inflation, which in core terms is already at its target. The Fed cannot tolerate above-trend growth much longer.”
As the US appears to be slowing, said Hatheway, there is no other market that can replace it with fears of weaker activity in China arising, Europe remaining stagnant and Japan and emerging markets looking “uninspiring”.
The post-peak environment is also about earnings, he said, which despite another strong quarter of year-on-year growth for the Q3 reporting season have failed to impress with investors more concerned about the outlook.
It is something that fund managers have become increasingly worried about.
The latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that 29 per cent of asset allocators believe global profits will deteriorate over the next 12 months, a six-year low.
Source: BofA ML Global Fund Manager Survey
Indeed, outside of the US – and with the lone exception of Japan – there are few signs of improving earnings, according to Hatheway, which again emphasises the lack of leadership from other markets.
“Post-peak has a final disturbing implication,” he added. “Earlier this year, when US growth was robust and accelerating, investors could climb the proverbial ‘wall of worry’.
“Today the same issues, ranging from the risks of trade conflict escalation to political uncertainty, Fed tightening or asset price valuations, have become paramount concerns.
“When growth is past its peak, the ‘wall of worry’ becomes tougher to surmount.”
Given the new market environment, Hatheway said the firm’s asset allocation committee has started to make changes to its strategy.
The “post-peak trauma” is unlikely to give way to a strong traditional fourth quarter rally – sometimes known as a Santa rally – said the economist, given the behaviour of investors over the past decade.
“For most of the past decade, investors have not bought assets merely because they were inexpensive, so more attractive values alone are unlikely to attract sufficient interest to lift markets,” he said. “Instead, investors require a catalyst to re-engage. Sadly, that catalyst is missing.”
US authorities are unlikely to have the ability to react to a slowdown after Donald Trump’s Republican party lost control of the House of Representatives to the Democrats in the US mid-term elections.
The result means that the controversial US president will face greater opposition to any new spending plans or catalyst that could help boost the economy.
Now, however, the firm ha begun to prepare for an environment of more uneven market performance and greater volatility, reducing equity exposure and concentrating on certain company types.
“Minimum volatility and higher quality growers, companies with resilient margins, are preferred,” said the GAM chief economist.
The quality style has outperformed growth not only during the past three months year but also during 2018 overall, with the MSCI ACWI IMI Quality index – an index of investable quality-growth companies – has delivered a total return of 1.58 per cent compared to the MSCI ACWI IMI Growth index.
The economist said the firm was also making changes to its fixed income strategy as part of the shift to the new paradigm.
“Given inflation and monetary policy lag the growth cycle, we prefer to remain short duration with a preference for specialty credit, such as non-agency mortgage-backed securities or insurance-linked debt,” Hatheway explained.
Real GDP quarterly growth vs Fed funds rate since 2000
Source: St Louis Fed
However, there were few changes to its stance on alternatives strategies with the committee retaining its preference for liquid alternatives, target return and alternative risk premia “to bolster diversification in multi-asset portfolios”.
Finally, Hatheway noted that the post-peak environment is implies lower returns and falling Sharpe ratios – a measure of risk-adjusted returns – suggesting investors may need to take on more risk to generate the returns they have become accustomed to.