Peering in the rear-view mirror, 2018 in hindsight could be characterised by slowing global growth, central bank policy tightening and escalating geopolitical risk. These are not features typical of a strong performance in risk markets. Yet for most of last year, markets climbed this wall of worry.
But as these features crystallised in Q4 — a quarter we spent predominantly underweight equities — volatility and “risk-off” sentiment took hold. Worries about slowing global growth, the US–China trade war and Brexit cemented a “worry wall” that was just too high for markets to scale.
This culminated in a difficult end for risk markets in 2018. Most major global equity indexes experienced double-digit falls in December. In contrast, more defensive government bonds rallied strongly, providing some protection for portfolios.
Looking ahead, 2019 may well be another difficult year. There has been some relief in the first few weeks of this year, with equities up over 6 per cent in January. But volatility remains elevated, a cautious attitude to risk is likely needed, and portfolio diversification (as always) will be key.
We continue to see 2019 as a year to “stay cautious, but stay engaged”. This was our headline for our 2019 outlook late last year. We are neutral risk, a position adopted in early December last year following the equity market correction in October and November — and we have held this position through the sharp gyrations of the markets in December and January.
For equities, we remain tactically neutral overall. But this month we are increasing the intensity of our preference for international over domestic equities. This reflects a combination of Australia’s recent relative outperformance, plus heightened concern about a housing correction and rising political risk ahead of an expected federal election in May this year. We are putting this to work in the emerging markets, where we went overweight in September; this has proved a good decision. With valuations still attractive and some potential for stabilisation of the economic and geopolitical backdrop, we add further to this position.
So, what has been weighing most heavily on markets as we settle into 2019?
Firstly, the geopolitical flashpoints of the US–China trade war and Brexit uncertainty. The late optimism surrounding the late November G20 meeting between US President Trump and Chinese President Xi Jinping proved short-lived. Despite a delay in 25 per cent tariffs until 1 March 2019, rhetoric from the US side initially provided little hope that a deal could be struck. In the UK, the impasse in Westminster kept markets on edge in Q4, with a worst-case no-deal/no-transition outcome staying “front of mind” ahead of the 29 March deadline.
The other significant factor weigh on markets over recent months has been the sharper-than-expected slowing in global growth. Weak external demand and weak business confidence were common features across both advanced and emerging economies. And the US government shutdown (the longest in history) added to market worries. The Federal Reserve’s December hike — the fourth in 2018 — caused the market to fret about the earnings outlook. All of this is likely to be revealed in continued poor trade and investment data over coming months. Australia’s growth also slowed significantly in Q3. Consumer sentiment and car sales also fell at the end of 2018 and retail sales slowed, likely in part due to the recent acceleration in housing market weakness.
Can calm return to markets as 2019 unfolds?
A number of developments have underpinned a more positive start to markets in early 2019.
In particular, the US Fed has recently significantly softened its prior hawkish tone, emphasising “patience”. While the global growth outlook has been trimmed, key forecasters such as the IMF and OECD still see a solid growth outlook near an average historic pace of growth. Further, China has made significant progress to meet the US’s trade concerns, suggesting a further hike in tariffs can be avoided for now, and China has also accelerated its stimulus measures. Finally, Brexit negotiations are inching towards a deal, or maybe another referendum!
Continued progress on these developments will be key to whether risk markets can face a more supportive backdrop as 2019 unfolds. If so, this could afford equities room to rise in line with current modest earnings growth outlooks. For Australia, H1 2019 is likely to carry challenges from uncertainty about the extent of the housing correction to elevated political uncertainty ahead of a federal election. As we noted last year, the potential for a change in government mid-May could see uncertainty weigh on a broad range of equity sectors, including health insurance, property, banking and utilities.
For markets, key will be the extent to which central banks’ withdrawal from further tightening — as well as renewed China stimulus — can elongate the later stages of this macro cycle, both drivers behind our recent return to a more neutral risk stance. Assuming some calming in global geopolitical tensions, H2 2019 may prove a better backdrop for moderate equity gains globally. For Australia, transitioning a mid-year federal election may also provide a better backdrop.
Scott Haslem, chief investment officer, Crestone Wealth Management
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