Many asset classes experienced negative returns in 2018. In fact, of the 70 assets we observed (including developed and emerging equity and bond markets, credit and commodities), 90 per cent of them posted negative returns last year – by far the worst return observed in the post-World War II era.
The year was also characterised by a number of volatility challenges. There was the VIX shock in early February, the sharp sell-off in Italian government bonds in May, emerging market stresses mid-year, equity and credit market downdrafts in Q4 2018 with US-China trade tensions, the Italy-EC budget stand-off and of course Brexit all adding to the uncertainty.
Risk assets have rebounded in early 2019, buoyed by perceptions of a more flexible Federal Reserve and an increased probability of some de-escalation in US-China trade tensions. However, economic news flow in early 2019 has continued on a somewhat disappointing trend, although not sufficiently so as to corroborate worst-case fears.
Outlook – slowing growth leads to policy support
Looking forward, global growth is projected to slow from 3.7 per cent in 2018 to 3.5 per cent in 2019–20, according to the OECD. The US continues to show economic resilience relative to the rest of the world as evidenced, for example, by the January jobs report and the partial rebound in the US ISM Manufacturing Index. But the risks continue to be skewed to the downside, and elsewhere, deterioration is more evident.
The slowdown in Asia is filtering into other parts of the world and this suggests that weakness in the manufacturing sector is yet to find its cyclical nadir. In Europe, Italy has entered recession while German manufacturing is in contraction mode. Indeed, the latest round of PMIs continue to edge lower with 71 per cent of the composite indicators we track in moderating territory and seven of the 21 manufacturing series we monitor now in contractionary (sub-50) territory.
How markets react to this fragile economic environment, in part, depends on expectations of policy action and its likely effectiveness.
At the January Federal Open Market Committee meeting, not only did they emphasise patience and remove references to “further gradual increases” in rates, but they made two references highlighting a benign inflation backdrop. This lack of inflation concern suggests that, while their future actions are data-dependent, in the near term it will be the fragile growth environment that is at the forefront of Fed thinking. This implies that the US tightening cycle has entered a phase where bond yields and the US dollar should face less upward pressure and this would in turn provide an element of support for risk assets.
Opportunities for alternative strategies
The choppy market environment we envisage in the first half of 2019 suggests that a wide range of total return strategies could be a potential driver of future returns. In the near term we favour range-bound strategies, but we believe that future pockets of volatility could present opportunities for alternative strategies, utilising options, that offer either a high degree of asymmetry in their payoff profiles, or wide buffers to protect us should risk-asset price weakness return.
Matthew Merritt, head of multi-asset strategy group, Insight Investment
