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  Asset Allocation January

23 January 2019

After already having struggled for most of the last quarter markets took a nosedive late December. Worries about slowing global growth and political tensions weighed heavier on investor’s minds than the possibility of the Fed holding off on more interest rate hikes or a truce in the US-China trade war. Positive returns were hard to find in 2018; apart from the very defensive assets there were virtually no assets that ended the year in the green. With markets at (multi) year lows they are starting to look somewhat more attractive on the face of it, but 2019 is promising to be a challenging year. A slowdown in global growth and a decline in earnings growth are all but certain. Together with uncertainty about central bank policy and political turmoil the outlook is clouded at best. Nonetheless we do see some opportunities and are cautiously adding some risk.

Grow, but slow

After the rapid expansion of 2017 and -18 growth will slow in 2019. That should come as no surprise, if only because the effect of the massive tax cuts in the US fade away. What was cause for concern recently was that we see leading indicators drifting lower. Economic data was a mixed bag, but certainly not strong enough to convince the market there was nothing to worry about. The same goes for the federal reserve. They raised rates in December and continue to drain liquidity from markets, but played down the likelihood of further rate hikes for next year. Given the current economic outlook it is likely the Fed will slow the pace of tightening monetary policy. Besides the Fed the Chinese government is also easing fiscal and monetary policy to stimulate the economy. Much needed as the impact of the trade war is starting to show, export growth is declining and the domestic economy is lagging. As policy worldwide is being eased there should be some positive effects on growth. The question is whether it is too little too late to stop the decline or if policy makers have done enough to extend the economic cycle even further. Add to that a number of important and unpredictable political developments, most notably Brexit and the US-China trade negotiations, and there are lot of paths for the next year. Some of which lead to serious adverse conditions for markets. When we examine the dynamics we looked for similarities in previous markets cycles. Sifting through the noise we find a lot that looks like 2015. As then leading indicators slowed, central banks were raising interest rates, oil and bond yields fell. Credit spreads widened and by early 2016 China stimulated growth and central banks paused. Our base case is that this happens again. This will set the stage for a tactical rally in markets. Markets have corrected by too much. However, we would caution against becoming too optimistic.

“The final weeks and days of 2018 were brutal and it clearly looks like 2019 will be as volatile.”

What’s priced in?

Given the uncertainty, it’s no wonder markets became more risk averse over the past few months. Equity markets ended December close to their lowest point for the year and corporate credit spreads widened to multi-year highs. We see value in credit markets as yields have increased significantly and now offer an attractive carry. We think defaults will stay low and thus markets have overreacted. The equity market seems to price in an outright decline in earnings for next year. Too pessimistic in our view. However companies are downplaying the outlook for next and analysts are lowering their expectations. Equity markets will continue to struggle with declining outlook and it is unlikely we will move back to the peaks of 2018 any time soon. However they have sold off too much to become outright negative now.

Cautiously optimistic

The final weeks and days of 2018 were brutal and it clearly looks like 2019 will be as volatile. Following the correction, the risks are now more balanced. Most of the house cleaning has been done and investors embrace the new year bruised, but with shiny new risk budgets. The narrative has clearly changed. We note that markets offer a better risk-reward and there is value emerging. The crucial question we asked ourselves is whether growth and interest rate expectations have adjusted enough to allow us to dip a toe in the water. Our answer is yes. There is a caveat though. We hold the view that there will not be an economic recession in 2019, but leading indicators have softened significantly. So, one has to be very nimble as the probabilities of an adverse outcome have increased and we would caution against becoming too optimistic.

Disclaimer
Kempen Capital Management N.V. (KCM) is licensed as a manager of various investment funds and to provide investment services and is subject to supervision by the Netherlands Authority for the Financial Markets. This information may not be construed as an offer and provides insufficient basis for an investment decision.

The Asset Allocation  Desk

Marius Bakker
Ivo Kuiper
Joost van Leenders

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