If you listen to various commentators talk about world equities, one would be under the illusion that the bull market days are numbered, especially after the recent falls in US markets. We would, however, argue that this is not the case, but not for the obvious reasons. The reality is that we are not in a bull market, and have not been in one for a while, with the only exception being the US stock market, and more specifically the US technology sector.
Lots of reasons have been given for the recent weakness, namely: rising US interest rates; trade war escalation; slowing global growth outside the US, emerging market woes, Brexit and Italy’s ongoing budget spat with the EU. Of all these reasons, we think the sell-off has more to do with investors re-positioning their portfolios for higher interest rates and the impact this could have on growth stocks, particularly those of technology companies.
This shift towards value stocks seems to happen regularly at the beginning of a new calendar quarter and then reverts to growth a couple of weeks later, as share buy backs by cash rich quality growth companies, which have been a strong driver of the US market, reassert themselves. The reason we argue that the bull market is not ending, is that other than in the US it hasn’t really begun. This is why we are not selling after the recent falls, as world equity markets (ex-US) are offering excellent value.
World equity markets
Source: MSCI, Thomson Reuters, RMB Morgan Stanley research
Our portfolios are also conservatively positioned, with a moderately underweight equity positioning relative to our long term strategic asset allocation weightings, by virtue of below-benchmark US representation ties and we are still cautious about aggressively increasing our exposure to emerging markets. For this exposure to increase, we need to see the Dollar fall, as Dollar strength and emerging market performance are negatively correlated – i.e. a stronger Dollar leads to weaker emerging markets.
Our fixed income allocation has been underweight for some time now, as we are of the view that the 30-year bond bull market is over and hence we do not want to have interest rate risk in our portfolios. Where we are invested in bonds, our exposure is tilted meaningfully towards floating rates instruments that gain when interest rates rise, as opposed to fixed duration investments.
We also have a sizeable allocation to alternative strategies funds across our risk rated portfolios, which are a natural beneficiary of the rising volatility that we have been experiencing lately. These funds cover a range of asset classes, but our largest holding is long / short equities which benefit when correlations between equities fall, or put differently they thrive in a market where stock-picking is paramount.
For us to reduce risk in our portfolios we would need to see signs of an impending recession in the US and for now, we do not see this as a worry, as, if anything, US recession risks are being pushed out to 2020 and beyond. Trade wars are impossible to call, but whilst we don’t see this potential disruptor going away anytime soon, the fact that the US is a fairly closed economy and China is now aggressively cutting taxes and increasing liquidity in the financial system to boost its economy means that their impact will likely be limited.
As for President Trump and the upcoming US mid-term elections, while it would appear that the Republicans might lose control over both the House (and possibly the Senate), this will not affect his tax cuts, nor curtail his fighting talk on trade war – so it’s still business as usual. Like him or hate him, the US economy has thrived under Mr Trump and we don’t see the mid-terms changing his ability to get things done.
In Europe, meanwhile, although Italian politics and the fragility of its banking sector remain cause for concern, we don’t see the ECB walking away if the bond market really starts to take strain: they might talk tough, but the Eurozone will more than likely bail Italy out if yields rise too high.
So to conclude, US stocks were due a correction, having been one of the only major markets to be in positive territory for the year and having outperformed all others for years now. Higher interest rates will lead to investors questioning valuation and it is healthy for a market to correct as asset markets reprice for this eventually. At the same time, rising interest rates on the back of stronger growth means that the corporate backdrop remains healthy, which is good for equities, so we are not reducing risk on the back of higher rates. If we are wrong and markets continue to fall, however, we should weather the storm better, as we have a large exposure to assets outside the US (which are offering far better value) and a broadly diversified mix of asset classes within our portfolios.
Download: Weekly Comment – October 25 2018 – JB