First, let me clarify a few of my thoughts:
I do expect a US slowdown, but I don’t expect a recession.
I do expect a further correction, but I don’t expect a sustained, deep bear market.
I do expect US equities to struggle, but I don’t expect all global equities to struggle.
My downbeat outlook for US equities doesn’t mean that investors should abandon equities entirely. Cash may once again be an investible asset, but with no recession in the foreseeable future, risk assets can still outperform. And active managers could still add value, even if US equity benchmarks struggle to make headway. I also think it’s a case of looking further afield globally and taking a more defensive position domestically.
Sentiment towards emerging markets still tends to be overwhelmingly negative, but some emerging reasons leave me cautiously constructive on some emerging regions. In Latin America, recent sharp moves have left valuations expensive; whereas emerging Asia is looking cheap on both relative and absolute bases. Fundamentals are also due for an upgrade: the various monetary and fiscal stimulus measures from the Chinese government should soon boost the Chinese economy, with positive repercussions across the region. Admittedly, a positive catalyst—perhaps a fading in US/China trade tensions, but more likely a weaker US dollar—may be required before emerging markets globally can outperform. But soon I expect there to be a good entry point for investors to build a long-term strategic position in Asia.
Japanese equities have also suffered a volatile year, but 2019 looks more promising. Not only are valuations attractive, but the Bank of Japan’s monetary policy normalization is likely to move at a snail’s pace. Some investors may have been a little worried by the activity contraction in Q3, but as Robin Anderson detailed in her blog, these fears are misplaced: GDP growth is due for a sharp rebound in Q4. Of course, with a weaker US dollar could come a stronger Japanese yen. While that would be a headwind to growth, Japanese company earnings have become less sensitive to currency moves, insulating them somewhat from a strengthening yen.
Europe could be a promising alternative given that the ECB has indicated it will keep policy rates on hold through summer 2019—but the subdued earnings outlook and lingering Italian political risk leave me less than enthusiastic.
In the United States, the less-friendly macro environment argues for protecting against downside shocks. It means positioning defensively in sectors like utilities, consumer staples, and healthcare, while avoiding rate-sensitive sectors such as autos and banks. In credit, it implies moving up in quality. And more generally, in both equities and credit, tightening financial conditions and elevated leverage mean that investors should seek out companies with strong balance sheets, high profit margins, and stable revenue.
In the last few weeks, equity market falls have coincided with (if not been driven by) a sharp widening in credit spreads. This suggests that simply diversifying between equities and fixed income may be insufficient. Real assets may present a solid alternative given that they tend to demonstrate lower correlations to market swings and can outperform in an environment of solid growth and low inflation. What’s more, if long-term US Treasury yields peak while the growth outlook is still positive, real estate investment trusts could be an attractive strategy.
Perhaps the most important message is this: with market volatility set to remain elevated in 2019, simply “riding the trend” of the market like in previous years will be a dangerous game. Market participants will need to introduce some downside protection to their investing, as well as deep knowledge of the different asset classes, regions, countries, sectors, and companies. In short, this is a stock picker’s market—a clear time for active investing over passive investing.
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