As The Tri Polar World Turns - December 2018
MACRO THEMES
The main question as we prepare to exit 2018 and enter 2019 is the following: Do the recent selloffs in global equity, tech, momentum, and oil point to a significant global growth slowdown or are they more a reflection of internal market driven dynamics? If the former, portfolios need to get and stay defensive; if the latter then the opportunity is likely to lie more on the risk taking front. In just the past week we have seen Chair Powell prep the markets for a data dependent Fed to pause, a cease fire break out in the US - China trade tiff, and OPEC signal that a sizable production cut is in the cards; all of which is supportive of growth & constructive for risk assets.
From an ECONOMICS perspective the big news is fiscal policy’s incipient return to the playing field. China stimulus in 2019 could equal 1.5% of GDP while fiscal stimulus in Europe could add 3 to 4 tenths of a percent to GDP, sufficient to stabilize Europe’s growth path. Only in the US is fiscal policy a worry, now that the bill has to be paid or at least the debt has to be raised to cover the huge gaping hole in US finances.
The sharp decline in oil prices should also benefit the rest of the world, including Europe, Japan, as well as much of the Emerging Market universe all of which are big oil importers. It's hard to see the catalysts for a sharp global growth slowdown when one takes into account fiscal stimulus in China and Europe, the growth benefits of low oil prices, and the positive impact of emerging economies having already gone through significant adjustment this year. Should there be a trade truce, China and Europe could get the truce juice while also benefiting from the fiscal stimulus. The weak growth risk would seem to lie mainly in the US where most forecast are calling for roughly 2.5% GDP in 2019, something the Fed seems to have cottoned on to. As we enter 2019, the surprise could be ebbing growth concerns in Europe and Asia and rising concerns in the US. (See Chart 1)
Chart 1: 2019 RoW Growth To be Better Than US
Source: Morgan Stanley
There is absolutely no shortage of POLITICAL issues to discuss: in the Americas one has both a gridlocked Congress & the Mueller investigation in the US together with new and unproven Governments in Mexico and Brazil. Across the pond in Europe, Brexit remains an open question while the European Commission (EC) - Italian budget dispute drags on and European Parliament elections slowly come into view. In Asia, China searches for trade allies, potentially speeding up the Asian integration process.
Much ink has already been spilled on all these topics suggesting that for the most part they should be well discounted. The Mueller investigation and the US - China trade dispute could still cause a big fuss. The 90 day trade cease fire is a welcome respite, a respite that is likely to continue for the foreseeable future as the issues on the table are much too complex to be determined in three months, strongly suggesting both sides see this as a drawn out affair that will go on up and thru 2020.
On the POLICY front the important news is the introduction of fiscal policy together with monetary policy in all three regions. As noted previously, fiscal policy is almost a case of the Good, the Bad and the Ugly. China’s use of stimulus to stabilize its economy and inoculate it from trade tensions represents the Good. The Bad would be Italy's unnecessary fight with the EC, now somewhat superseded by a broader use of fiscal policy throughout much of Europe (see Chart 2). The Ugly is the US hangover from its earlier fiscal stimulus, one that is likely to result in higher rates at the long end of the UST curve as supply demand dynamics prove challenging.
Chart 2: Fiscal Policy Supports 2019 EU Growth
Source: WSJ
There is a case to be made that Europe in 2019 will be much like the US in 2018 when fiscal stimulus allowed the Fed to raise rates without slowing the economy. Europe did not have the fiscal boost in 2018 and could not exit from QE. Next year, expect Europe's fiscal boost to allow the ECB to exit QE and begin to raise rates. Given how well this policy mix worked in the US one is surprised by the lack of enthusiasm for Europe’s prospects next year.
US Monetary policy remains front and center, with a growing sense, as seen in the Fed Funds futures, that the Fed is likely to pause in its rate hiking process most likely in March. Much of Wall St is still in the 2-4 hike camp for 2019 suggesting a lot of room for forecasts to change as we go thru next year. A Fed pause is likely to lead to a USD rollover and the potential for the markets that led us down to perhaps lead us back up (what we call FIFO).
Thus to MARKETS. Financial market moves in 2018 have been both broad and deep; broad in the sense that the vast majority of financial assets are down year to date and deep in that several major market segments, the FAANGS, oil and EM all have had significant sell offs in the space of a few weeks. This may have the benefit of setting us up for as decent 2019 (to be discussed in the 2019 Outlook in a few weeks) given that unlike a year ago sentiment is poor, positioning is light, leverage in nonexistent, and equity market valuations are much more reasonable particularly ex-US.
The convergence trade we have been discussing for some time has unfolded as markets discount the 3Ts: Trump, Trade & Tech. 2019 US EPS estimates are converging with Europe and EMs. Equity markets have rerated downwards with the US experiencing its 3rd largest equity valuation contraction since 1990 (See Chart 3). It's likely that earnings growth will drive much of equity market returns in 2019 given that multiples will struggle in a decelerating global economy where monetary accommodation is being removed.
Chart 3: Flat Mkt + Strong EPS Growth = Sharp Multiple Compression
Source: WSJ
PORTFOLIO STRATEGY AND ASSET ALLOCATION
Given our outlook for gently decelerating global growth we continue to favor global equities over bonds and maintain positions in energy related alternatives. The trifecta of dovish Powell comments, a China-US trade truce, and likely OPEC production cuts has led us to increase the risk in our portfolios. In essence, while markets remain volatile we believe there is a playable rally in risk assets ahead.
Within equities, we remain relatively defensively allocated in the US, maintain our European exposure and have added to our Asian exposure via a China specific allocation to benefit from China’s fiscal stimulus. We also added Latin American equity exposure as Brazil enjoys a cyclical economic recovery while Mexico has been deeply oversold.
In Fixed Income we have added to EM local currency debt believing that EM FX has most likely bottomed versus the USD. We now hold positions in both EM USD debt as well as EM local currency.
In addition, we have exited our US IG position given recent dislocations but remain constructive on US HY which remains supported by favorable supply – demand characteristics, declining default rates and the lack of repayment mountains. We believe the BBB monster fears whereby downgrades crash into US HY and capsize the space are overblown and present an opportunity. Our expectation for better EU growth leaves us with minimal exposure to non-US sovereign debt positions.
Within our Alternative sleeve we remain focused on broad commodity exposure with a tilt to energy via our MLP position. This position held in pretty well on a relative performance basis in a very tough November and should respond favorably to OPEC production cuts.
We maintain solid cash positions given the uncertainty around leadership within the equity space, both geographical and sectoral, while supply - demand risks are rising in the UST market.
GLOBAL MACRO SUITE PORTFOLIO CHANGES
Global Macro Multi Asset (GMMA)
Within equities, we exited our US Industrials position and reduced our broad US Min Vol position. We initiated a position in global innovation (big data/ analytics, fintech, robotics, etc.) using the recent tech sell off to enter a space with great growth characteristics. We added to Emerging Markets in both Latin America & Asia (broad Chinese equities) bringing us OW Asian equity.
On the fixed income side we exited our US IG position given recent dislocations. We added to our EM debt exposure but this time in favor of Local Currency denominated debt which should benefit from a bottoming in EM FX vs the USD.
Global Macro Income (GMI)
As in the GMMA portfolio, we eliminated our US IG position and added an EM Local Currency position while also adding to our UST belly position.
Global Macro Equity (GME)
As in the GMMA portfolio, we exited our US Industrials position, reduced our US Min Vol position, added a position in global innovation (big data/ analytics, fintech, robotics, etc), initiated a Chinese equity position, and added again to our Latin America position (2nd increase in two months).
We exited our French equity position and replaced it with a position in Dutch equity which should benefit from that country's fiscal stimulus program. (See Chart 2)
We slightly reduced cash to participate in what we expect to be a risk on rally.
We hope you find this monthly piece of value and look forward to engaging with you on a monthly and quarterly basis. Please be on the lookout for our 2019 Outlook piece due mid-month.
Jay Pelosky, CIO & Co-Founder
TPW Investment Management
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