December 2018 - Setting the Stage for a Year-End Rally
Global equities managed to rebound slightly during November, but it wasn’t a smooth ride. The MSCI All-Country World Index rose 1.3% on the month, due to a 3.3% recovery in the last week of the month. The main catalyst behind the recent rebound was Fed Chair Powell’s comments about rates being close to the neutral rate, a reversal of his statement in October which said they were far from neutral. The market has taken his recent comments in stride and are now pricing in only 1.3 hikes next year. Our take is that the Fed will become much more data dependent next year and strong data could still mean the Fed hikes 3-4 times. The market appears to be complacent at the moment about the Fed’s rate path for 2019, but stronger U.S. data and a high median dot plot at the next FOMC could reverse the market’s optimism.
The tariff truce agreement between Trump and Xi is another positive catalyst for the stock market in the near-term, and equities and risk-assets have responded positively to this announcement. Our view is that while this is certainly a near-term positive, tough negotiations are bound to be fraught with pitfall and both sides are simply avoiding the worst-case scenario for now. We advocate selectively adding to markets that have been negatively impacted by trade wars, such as EM equities and German equities, but expect risks to re-emerge in a couple months. The mitigating factor for global growth and China-sensitive assets is that Chinese policymakers have ample room to implement more stimulus should future talks fail.
In European equity markets, stocks continued to underperform other regions in November, with the MSCI Europe index down 1%. Although political risks stemming from Brexit and Italy remain on the agenda, valuations continue to look attractive relative to the U.S. with stocks trading at a 2019 earnings multiple of 12.4x compared to 15.6x for U.S. stocks. With core inflation unlikely to pick up materially in Europe, the ECB will likely keep rates unchanged which should support European equities, whereas U.S. equity markets will continue to be driven by high-growth stocks which should be volatile. Elsewhere, we think that Japan’s attractive valuations (FWD P/E of 12.3x) as well as the BOJ’s loose monetary policy can continue to drive gains, especially among sectors that are exposed to trade wars (autos, tech). EM equities rebounded nicely on the month (4% total returns) and we think there is further room to go given cheap valuations and the reaction to the trade war truce.
In credit markets, riskier parts of the market continued to underperform as the broader asset class is on track for its worst year since 2008. Spreads for US HY widened another 48 bps on the month and total returns were -0.9% (0% YTD), making valuations relatively attractive. The big drop in oil prices (-22%) weighed on the US HY energy sector, which accounts for 15% of the market. US HY energy credits lost -3.6% and spreads widened 111 bps, marking the worst month since January 2016. Our view is that absent a drop below $45 a barrel, U.S. producers will be able to withstand the market volatility given their lower cost structure compared to the past. US IG spreads widened another 20 bps on the month (-0.2% total returns) driven by idiosyncratic credits and weaker technicals (fund outflows and weaker foreign demand). Our view is that market concerns about the massive growth of BBBs are overblown and the asset class presents an interesting entry point given wider spreads. Elsewhere, European credit markets fared even worse, with IG and HY total returns of -0.6% and -2% respectively. In Emerging Markets, currencies rebounded vs. the USD +1.6% on average in November, led by the Turkish Lira which appreciated 7% on the back of easing relations with the U.S. as well as lower oil prices. Currencies of other oil importing countries (South Africa, Indonesia and India) also outperformed, while laggards were the Argentine Peso and Brazilian Real. EM USD credit spreads widened 27 bps (-0.2% TR), negatively impacted by lower oil prices, while local currency bonds returned +2.2% in USD terms. We see more value in local currency debt vs. USD debt, given higher real yields and a lower exposure to oil prices. Nonetheless, country and credit selection remain important.
Overall, the trade war truce and potential for a shallower path of Fed hikes have led to a nice rebound in riskier assets which may lead to a nice year-end rally following a dismal year. Given the length of the bull market and the possibility that these risks could re-emerge, we caution against being overly optimistic in the medium-term. We see more room for a rally outside the U.S. and advocate gradually building up cash levels. As always, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance.