After two years of positive performance across the board, with almost no asset class in negative territory, 2018 is marking a change of direction, with an unprecedented percentage of asset classes in red. This may cause a sense of uncertainty among investors facing uncharted waters ahead. The challenge has been even bigger for European investors still living in a zero-rate era, facing an environment of no returns on the bond side and losses across all risk assets, exacerbated by idyosincratic stories such as the Italian budget confrontation and by the still uncertain Brexit scenario.
To navigate this market phase, we must recognise that investor sentiment, more than fundamentals and instrinsic value, is driving markets today. In fact, on one side the economy remains resilient, but after a very long expansion, the feeling that the music is changing and we may be heading towards a recession in the next couple of years, is gaining ground. The economic slowdown is occuring at diverging rates and at a time of profound transformation in global trade dynamics. This, compounded with the geopolitical tensions and the fact that the earnings peak is behind us, is increasing the risk that an already very long cycle may be nearing its end.
We don’t buy the view that the cycle is over yet, though risks are certainly tilted on the downside. In our view, instead, in an era of the dominance of politics, where sentiment can move fast, some of the recent market moves have the features of an overshoot on the downside that can offer opportunities for long-term risk-taking, bearing in mind that short term volatiiliy will persist. This caveat is key, especially at this stage of the cycle and with still high political uncertainty.
The big question is, therefore, if it is time or not to increase risk allocation and how. We call for starting the year with a defensive stance on the core allocation, with a focus on quality, value and liquidity and adding risks throughout the year in oversold assets that may offer compelling long-term risk-adjusted returns, while keeping a strong focus on sustainability of debt and earnings growth. In this respect, the areas where we see most opportunities to be played in 2019 are Emerging Markets (both bonds and equities) as we approach a possible pause in the Fed hiking cycle that could benefit these investments and European equities, once some political risks will diminish after EU elections.
Patient and selective investors, able to look beyond short term noise and accept the higher volatility of a late cycle featuring rising political risks, will be able to navigate these uncertain waters. Asset managers, on their side, should answer these challenging times by launching innovative solutions to help enhance risk-adjusted returns, manage behavioural risks and increase the likelyhood that investors will reach their goals. Alignment of goals, investment horizons and risk tolerance (keeping in mind that today’s environment may require some additional risk taking) will be the compass to navigate with success this new market phase.
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