by Olivier d'Assier
For the first time in a decade, risk-free assets are competing on par with risky assets and perhaps even more favorably if looking at the current levels of volatility: 17-20% in the equity market versus 3% in the treasury market.
Against this backdrop where market consensus is at or near the top of the economic cycle and global growth is decelerating, we put to Olivier d’Assier, Head of Applied Research for APAC, some key questions on risk for the coming year.
Q: Where are the opportunities?
A: Volatility in equities, which hovered around the 10-12% level in 2017, will remain higher in 2019 at the 17-20% range. This means either your return expectations have to be higher than in 2017 or 2018, or, your confidence in them has to be. Given the base consensus forecast for 2019 and the increased uncertainty of the current geopolitical climate, neither seem likely so a de-risking rebalancing has to take place.
On the bright side, equities and bonds should continue to be negatively correlated, offering a nice diversification benefit at the portfolio level. This is why we are seeing strong demand for treasuries and high-grade corporate bonds this Q4 as investors reinvest what they sold in the equity markets into safe treasury and high-grade corporate bonds. A best-case scenario for 2019 sees all of those geopolitical headwinds (Brexit, the trade war, the US shutdown, Italy and the EU budget crisis, Fed rate hikes, etc.) get resolved. Investors may keep an exposure to equities at first as long as they hold out hope for this scenario, but if evidence to the contrary rolls in, then the great rebalancing will gather speed.
Q: What are you cautious on?
A: My big concern is that investors go into 2019 with false assumptions about their potential losses as they rely on recent volatility and correlation regime to estimate their predicted loss. If your return forecast is based on a slow economic growth scenario and higher interest rates, then you have to throw away both the volatility and correlation data of the past few years which were under rapid economic growth and an accommodative Fed.
What worries me aren’t unseen risks, but forgotten ones that come back to light under a different environment. The world binged on debt during the QE decade, and while we may have been able to ignore it in a high-growth economic world, lower earnings ahead, a stronger USD, and higher US interest rates mean that pressure which wasn’t being applied previously will be now just as most of the bill comes due. We have already seen the weaker segments of the market like Emerging Market High-Yield USD debt under pressure with spreads doubling or tripling in some cases. This hasn’t yet hit the investment grade bond market and the spread gap between IG and SUB-IG bonds is still widening, but that only means a lot more downside for the latter if the stress gets too much.
Q: Has your market strategy/outlook changed recently?
A: We don’t make returns forecasts but instead help our clients construct portfolios that are the best representation of their own forecasts. Having said that, in speaking with them, they have changed their views on 2019 several times. Although the consensus is for slower growth, there are several risk factors that could change that scenario for the better or for worse.
This has given rise to a three-scenario (base, best, and worst-case) type of asset allocation. Just a month ago the base case was the favorite with the worst case a distant second and the best case only gathering nominal votes (i.e. an 80%-15%-5%). However, the base case at the time of writing remains favorite, maybe with 70% of the votes, followed by the best-case at 20% now that we seem to be getting a pause in the US-China trade war, and the worst case at just 10%. The probabilities for each scenario are changing every day though, as geopolitical news unfolds.
Q: What are the contrarian market views?
A: The problem with contrarian views is that by definition they have lower odds than consensus views, so the real question is how much more return are you expecting from those bets to justify taking on more risk? You also have to take a view on how long your investment horizon is (i.e. how long are you willing to bet against the trend), and how much can you afford to lose if you are wrong? The consensus view says buy defensive assets, like consumer staples, health care, F&B, investment grade bonds, treasuries, low-volatility and value stocks, etc. The contrarian view is to buy high-yield bonds, EM stocks, growth and momentum companies, Oil, and try to capitalize on a year-end rally. But a contrarian view only pays off if it becomes the consensus view at some point in the future and others follow your lead.
Q: Is the trade war still a risk for this year?
A: The trade war is a long-term issue and not one that gets resolved in a single dinner date. If anything, the admission that the WTO has failed in its purpose sends the message that it’s back to the drawing board on global trade, so we’re in this for the long-term. As far as the US-China trade war is concerned, we’ve just had a pause in the hostilities – or have we (the Huawei detention)? There is nothing in recent events that signifies the end of the trade war, hence the base case of slower global growth next year remains intact.
Q: What’s the impact on investors?
A: The de-escalation of tensions with the US halting its tariff salvo and China agreeing to some changes and the purchase of more soy beans and a few extra Chevys isn’t anywhere near the structural changes that the US is demanding. So, at best, it simply provides investors with more time (i.e. a lower volatility environment) during which to rebalance their portfolios for a downcycle economy over the next 3-5 years. Investors, it seems, are not willing to bet on either side right now and prefer to head for the sideline and the safety of treasuries and cash. In order to assess the market impact of these policies, both for a positive and negative outcome, you need to use two different volatility and correlation regimes.
Q: What are the best- and worst-case scenarios?
A: In a best-case scenario, look for inflation fears to return, consensus on Fed rate hikes to increase to three or four next year and chose a correlation regime where both bonds and equities are positively correlated with each other. In a worst-case scenario, simulate a flight-to-safety environment where equities and bonds become very negatively correlated, markets price in only a single additional Fed Rate hike, Japanese investors repatriate their overseas investment home (i.e. the JPY gains strength on safe-haven buying), oil goes down further, gold goes up, and the US yield curve inverts. All these are simple to model in the Axioma Risk platform.
