Slower Fed tightening poised to revive risk assets

Last year was challenging for most investors. It started with known unknowns, in particular uncertainty over the exact path of monetary policy normalisation and the outcome of Brexit negotiations.

But investors were also confronted with a number of unexpected challenges: the US took a more aggressive stance on trade than most investors thought likely; Italian elections produced a populist government that took a confrontational approach towards the EU; and there were wild swings in energy prices, driven by both supply and geopolitical concerns. 

Most importantly, growth in China and Europe weakened considerably while the US economy powered ahead until recently. It is this regional divergence that constituted the biggest surprise for investors and led to the unwinding of large positions. More specifically, the strength of the US economy relative to the rest of the world drove US real yields up and the US dollar sharply higher as the Federal Reserve turned more hawkish than markets were pricing in.

This, along with the worsening trade outlook, had a damaging impact on emerging markets. Europe suffered as well due to its strong trade links to China and other EMs. Investors were not fully positioned for these unexpected developments. At the beginning of 2018, shorting the dollar and being overweight European and EM equities against the US was one of the most popular consensus positions.

But in the year ahead these divergences are likely to dissipate and even partly reverse. The US economy’s outperformance was largely driven by the tax cuts enacted in late-2017, a one-off boost that is starting to fade. Meanwhile, the stronger US dollar should weigh on the US economy in 2019. It is also likely that non-US growth improves as the one-time negative factors, in particular the drag from the auto sector, reverses. 

With moderately slowing US growth offset by improving non-US growth, the US dollar should stabilise — not least because the Fed is likely to tighten monetary policy less than what was feared until recently. 

A slightly weaker US dollar should provide further relief to EMs, and any improvement on the US-China trade front would be an additional boost to EM assets.

A slower trajectory of Fed tightening is one of the key reasons to be cautiously optimistic that risk assets will regain their footing in the coming months. At the same time, it is essential that the global economic upturn continues; if any major economy enters recession, the outlook for risk assets would clearly dim.

However, we are confident that this economic cycle is not over for the following reasons: 

• Monetary policy remains clearly accommodative in most advanced economies, including the USA; 
• While the US fiscal impulse will gradually fade, fiscal policy elsewhere should be neutral or slightly expansionary. Germany clearly has ample leeway to ease policy, and the political tensions in the Eurozone may provide an added incentive to do so; 
• Although China is unlikely to return to fiscal and credit profligacy, investors should expect its leadership to do enough to maintain growth at about 6%. If trade tensions were to remain at current levels or even dissipate, China’s growth may even surprise to the upside; 
• Inflation is likely to remain subdued, which in turn will reduce pressure on the Fed to tighten too much;
• Political tensions will subside in Europe as the nature of Brexit becomes clearer; the EU and Italy already seem to have settled their differences; 
• Imbalances in EMs, which contributed to this year’s setbacks, are being mended;
• If the global economic expansion continues, corporate earnings will carry on growing as well. The sharp drop in equities in recent weeks has brought prices to levels that discount a worse earnings outcome than is likely. 

For these reasons, we enter the new year with a moderate growth tilt in our portfolios, expressed via a preference for global equities and commodities over fixed income and real estate, and an overweight in the hard-hit EM assets.

But if benign inflation fails to materialise, uncertainty over Fed policy would once again intensify, which would likely result in a renewed setback for risk assets. As the global economy emerges from a protracted period of ultra-loose monetary policy, it is to be expected that markets continue to face bouts of volatility as the Fed gradually withdraws its put. This is a reason to keep risk exposure relatively low, so capital can be deployed when such volatility produces opportunities. 

However, the key to our investment stance is that we see good reasons for this economic expansion to persist, while the risk of recession still seems limited - at least as far as we can tell.