The temptation of missed opportunities
The ferocious equity market rally through Q1 2019 has largely unwound the bear market experienced through 2018. But one of the key refrains heard through Q1 has been that this has largely been a flowless rally. This means that after being burned through Q4, many investors have been sitting on the sideline and missed the upside opportunity. These investors now face the temptation of chasing missed returns in the hope the rally continues. When markets move aggressively, we think it is even more important to have a repeatable, fundamentals-based and credible investment process to rely on. This allows us to ask:
- Have the underlying fundamentals changed materially?
- Does the market pricing reflect the underlying fundamentals?
- Is this a sentiment and momentum driven price action?
- Which asset class will give us the best risk adjusted returns over the medium-term?
Table 1: Equity markets have rallied aggressively to end March-2019
Have the underlying fundamentals changed materially?
We expect a recession to take place in the US at some stage near the end of 2020. That has been our base case through 2018. Leading indicators began to support that thesis in late-2018.
Fig 1: The US Manufacturing PMI has peaked, suggesting slowing (but still positive) growth
Leading indicators of US growth peaked and have turned lower (Fig 1). The US yield curve inverted (Fig 2). This means that longer dated Treasury yields were below shorter dated Treasury yields. Yield curve inversion has been a reliable indicator of recession for decades. The probability of recession in the next 12 months has picked up (Fig 3). We expect it will increase further over the next 12 months.
Fig 2: The US Treasury yield curve has inverted across several maturities
Fig 3: The probability of recession over the next 12 months is at the highest level since 2007
We have not materially changed our fundamental economic outlook. We continue to expect growth to slow through 2019 and 2020. After a lengthy period of economic expansion, we think economic risks are skewed to the downside.
Does the market pricing reflect the underlying fundamentals?
We think that the recent surge in equity prices does not reflect a material change in the fundamental economic outlook. Instead, our models suggest the current price level through most of the developed and emerging market equities is discounting earnings growth materially higher than what is likely to be achieved on average over the next five years. Mispricing is also evident in bond yields, in our view. The bond market currently is priced for modest rate cuts over the next 5 years (Fig 4). We think that means the bond market has started to price the possibility of a recession at some stage.
Fig 4: US bond yields are priced for moderate rate cuts over the next 5 years
We estimate that around 400-500bps of rate cuts are required to drive a recovery in the case of recession. Bond yields are currently discounting 50bps of cuts. There is scope for further decreases in bond yields (or increases in bond prices) as the market moves to fully price in a recession.
Is this a sentiment and momentum driven price action?
The rapid and violent price action in Q4 2018 pushed market sentiment sharply lower. Sentiment improved sharply in Q1 2019. This reflected several improvements, including:
- The pivot towards fewer rate hikes from the US Fed
- Expectations for a positive outcome in US-China trade negotiations
- Stabilizing economic data in China
During Q4 2018, speculative positioning became very net short across many key assets, including the S&P500 (Fig 5). That reversed in Q1 2019. We think that helped push the broad market index higher.
Fig 5: Speculative net positioning become very long the S&P500
Which asset will give us the best risk-adjusted returns over the medium-term?
Our investment process compares prospective risk-adjusted returns across asset classes. We then allocate to those that offer the best risk-adjusted returns. The recent equity market rally has bought forward returns from the future. The result is that prospective risk-adjusted returns are low relative to history. We also expect average annualized returns to be low in an absolute sense, given our forecast for recession. In contrast, we think bond yields are not yet fully discounting a recessionary outlook. In this scenario, we expect central banks around the world, including Australia and the US, will conduct quantitative easing. Risk-adjusted returns look reasonable despite the relatively low yields on offer currently. One of the outcomes from our investment process is that we avoid trying to pick tops and bottoms in the market. Instead we aim to allocate to assets that look undervalued relative to our view of fair value. Our overweight to China at the end of 2018 and through Q1 2019 is an example. On the other hand, we allocate away from assets that look overvalued relative to our view of fair value. Our move to underweight equities in late-March is an example.
Sticking to our processes means we avoid the regret of being out of the market during a rally and the temptation of chasing a rally that has already happened. Right now, sticking to our process means that we think:
- Fundamentals have not changed materially. Recent data reinforces our base case of a recession in the medium term.
- Market pricing (with the recent price rally) does not reflect the underlying fundamentals.
- Sentiment and momentum driven price action are key drivers of the recent equity rally.
- Our clear, repeatable process will deliver the best risk-adjusted returns over the medium-term.
Data sources: Bloomberg LP, Oreana Financial Services
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