SOMETIMES STARS SEEM TO ALIGN; OTHER TIMES THEY SIMPLY DON’T, NO MATTER HOW MUCH YOU TWIST AND TURN.
And sometimes a directional view on markets is clear, while at other times being a little more nimble and tactical is the prudent approach. We certainly acknowledge that the dovish pivot from the Federal Reserve (Fed), as well as other central banks, helped fuel a sharp rebound in risk assets over the first quarter. It has probably also extended this cycle a little. Nevertheless, we can’t shake the nagging feeling that asset markets are merely desensitized to the macroeconomic challenges that fueled the late 2018 sell-off even as those issues still lurk just beneath the surface.
We are unconvinced that the Fed’s pivot fired the starting gun on an extended, 2016–17-style rally: Financial conditions may have eased, but the economy is in later cycle, and there is less scope for an unleashing of pent-up demand. For all that, we have observed enough of the vagaries of post-global financial crisis (GFC) central bank maneuverings not to want to stand in the way of easier policy. This leaves us in a somewhat unsatisfactory holding pattern, and we expect equity markets to trade sideways in a range for the time being, while carry assets and duration remain supported.
From a macroeconomic perspective, let’s start with the good news. The objective probability of a recession in the next 12 months remains low by late-cycle standards. And with the Fed communicating a pause in its rate hiking cycle, we think the business cycle is probably extended by a couple of quarters. With higher frequency macro data at a low ebb and corporate earnings forecasts back to levels commensurate with slightly subtrend global GDP growth, the frothy sentiment of 2018 has dissipated and there is potential for modest upside surprise in the next quarter or two.
This, however, could be as good as it gets. To be clear, we are not outright bearish, but equally we struggle to see the catalysts to build meaningful upside momentum. Our principal concern is that once the Fed judges its dovish pivot to have been successful — as evidenced by data and asset market performance over a relatively short time frame — the easy policy tone will start to reverse. We acknowledge that Fed members have tacitly stated they will run the economy a little “hot,” but tolerating inflation a couple of tenths of a percent above long-run targets strikes us as tepid at best.
While we think that investors could be overestimating how dovish the Fed is on rates — we expect one or two hikes yet to come — equally we believe that investors may be underestimating how dovish the Fed is on the balance sheet. The stable level of reserves the Fed is targeting implies a larger balance sheet than hitherto assumed, suggesting that the Fed could end the balance sheet runoff as early as 3Q19. A combination of unexciting, slightly subtrend growth and monetary policy that is anchoring longer-end yields might not set equity markets on fire, but at the same time it supports carry assets and puts a floor under risk assets and sentiment — for the time being.
At the global level, trade is still the biggest macroeconomic swing factor. Recent trade data are understandably muted, so any accord reached between China and the U.S. is likely to provide a boost. However, we conclude that structurally the two sides remain divided on many issues; as a result, we would interpret any agreement as a cease-fire rather than a lasting resolution. Europe has suffered from the Sino-American trade spat despite not being the direct target, with trade woes coming on top of a slide in domestic demand and an uptick in political tension. We anticipate a modest rebound in European higher frequency data but expect any turn in sentiment to be muted, at least until after the European Parliament elections in late May.
While the economic outlook is neither hot nor cold, Goldilocks it isn’t. In our multi-asset portfolios, we maintain the slight underweight (UW) stance to stocks and the overweight (OW) to duration, but in both cases we expect markets to be quite range-bound. At the margin, we are increasing risk appetite modestly but feel this is best expressed in carry assets and so take credit to a small OW, preferring U.S. and European high yield (HY) and emerging market (EM) debt over investment grade (IG). At the same time, we take cash back to neutral and feel that the small OW we ran in U.S. cash over the volatility of late 2018 did indeed provide us welcome flexibility in our portfolios. Within equities, we continue to favor U.S. over European stocks, and we are becoming incrementally more positive on emerging markets. In FX, we believe that any rebound in the European data will impact the currency first, and so we replace our modest JPY OW with an EUR OW.
Our allocation today could be reasonably interpreted as a staging post. But in any journey, when the map is a little unclear, a staging post can be a welcome opportunity to reassess and, most importantly, gather further guidance for the next leg.
KEY THEMES AND THEIR IMPLICATIONS
Source: J.P. Morgan Asset Management Multi-Asset Solutions; data as of March 2019. For illustrative purposes only.
ACTIVE ALLOCATION VIEWS
These asset class views apply to a 12- to 18- month horizon. Up/down arrows indicate a positive () or negative () change in view since the prior quarterly Strategy Summit. These views should not be construed as a recommended portfolio. This summary of our individual asset class views indicates strength of conviction and relative preferences across a broad-based range of assets, but is independent of portfolio construction considerations.
Source: J.P. Morgan Asset Management Multi-Asset Solutions; assessments are made using data and information up to March 2019. For illustrative purposes only.
Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility.