By Hottinger Investment Management
After one of the most torrid Decembers on record for equity markets, valuations returned to attractive levels while geo-political events aligned to create a good environment for risk assets in January. The MSCI World index bounced 7.68% during the month, the best start to a year since 1987, having lost 10.44% over 2018. Emerging markets have been the recovery story of the month, albeit from a low base, gaining 8.7% in USD terms. This recovery has been helped by the Dollar Index weakening 0.62% and oil bouncing 12.62%, leaving Brent once more above $60 per barrel.
However, we are not convinced that the environment is right for a sustained outperformance of emerging markets. China’s growth prospects surprised on the downside in December with the Chinese economy during Q4 2018 expanding at 6.4% annualised. Meanwhile, despite the euro area as a whole growing at 1.5% annualised in Q4 2018, Italy is in recession and other major economies such as Germany are teetering on the edge of recession. Both China and Europe are important trading partners for developing economies.
Furthermore, the performance of emerging financial markets is negatively correlated to the US dollar. The weak start to the year for the dollar, we believe, represents the recalibration of the Fed’s interest rate policy as outlined by Governor Powell at the January Federal Open Markets Committee (FOMC) meeting.
In the January meeting of the FOMC, Jay Powell announced that the central bank remains neutral on interest rates, which means that the next move could be a rate rise or a rate cut. This is now in line with the most recent investor expectations. He also said that sales of bonds on the Federal Reserve’s balance sheet could be ended at the bank’s discretion and therefore earlier than originally expected.
This means that the pressure for the dollar to appreciate has weakened, supporting sterling strength during the year and limiting any weakness in the euro against the dollar. One might say that this is supportive of emerging markets which have a large share of dollar-denominated debt, central banks that are depending on the Federal Reserve’s interest rate policy, and companies with a currency mismatch on their balance sheets.
However, with financial markets now pricing in no move in Fed rates this year, the risk for the dollar is to the upside. The fundamentals of the US economy could see the Fed stick to the dot plot and move twice in 2019, which is now no longer priced into the currency markets.
Figure 1: Data accurate up to and including 25th January 2019. Source: Bloomberg
It could therefore be argued that there is no further justification for increasing emerging market positions, but some would consider this a contrarian view.
Brexit uncertainty continues to dominate in the UK, with Theresa May suffering a major defeat in Parliament over her deal and signs that MPs are trying to take control of the process. The important points from the market’s perspective are that there is a majority amongst MPs against a no-deal Brexit and it would seem that if the Irish backstop could be re-negotiated then there is a possibility of the May deal being passed. Any sign that the final scenario will not undermine the economy significantly will be taken well by markets as the 2.52% gain in the Pound Index in January shows. However, the underperformance of equities (FTSE All-share was up only 4.10%) suggests that UK risk assets remain unpopular with investors.
It was also the best start to a year since 1987 for the S&P 500, gaining 7.87%, with all sectors in positive territory and many value stocks performing well. Somewhat inevitably, the FANG+ index gained 13.10%, outperforming the main indices and showing that many of the same stocks continue to lead a market that is fuelled by momentum and still not working off fundamentals. This has all the makings of a “V” shaped recovery in equities, investment grade and high yield credit – much like the aftermath of the February correction in 2018 – leaving us still feeling a little cautious.
Central banks are reported to have been amongst the largest buyers of gold in 2018 and gold was up another 3.02% in January, taking it through the psychological level of $1,300. This shows, perhaps, that we are not the only ones feeling a little restrained with regards to the medium-term outlook.
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
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