INVESTORS MUST REALISE THAT 2018 WAS NO ABERRATION / THE FINANCIAL TIMES MARKETS INSIGHT

Investors must realise that 2018 was no aberration

The level of uncertainty facing investors in the new year is particularly acute

Nikhil Srinivasan


© FT montage; Bloomberg


Being wrong does not appear to be a restraint for those making market predictions. The S&P 500 is down 7.7 per cent for the year while the 10-year US Treasury yield isn’t that far from where it began the year. That is quite the opposite of what was being forecast.

This won’t temper the soothsayers, so let me add my two cents worth. I admit to being uncertain about the near term and so prefer to rely on the facts at hand. The facts suggest one should maintain a short duration on assets across the board.

First, there is no inflation anywhere that matters. Wage increases haven’t turned into runaway inflation in the US, Chinese inflation is subdued and European inflation expectations keep being revised lower.

Second, China’s economic growth is very slow. Irrespective of whether Beijing strikes a trade deal with Washington and some reasonable fiscal measures (eg tax cuts) are introduced, the world’s second-largest economy is slowing. Just look at auto, construction machinery and home sales — not to mention household debt levels that have tripled in less than a decade.

There should be a strong attempt from Beijing to reflate the economy and weaken the currency. It’s the right thing to do but will have consequences for asset prices globally.

Third, the US can fund its fiscal deficit. There have been plenty of market calls on the trillion dollar-plus deficit forecast for 2019 and the need for higher yields to ensure funding. So far, the calls have been, well, wrong. The 2018 deficit should come in at about $800bn with the 10-year bond yielding about 2.75 per cent. Go figure. The dollar is the world’s reserve currency with no competition for the moment.

Fourth, volatility in markets is not just a creation of American policy. Don’t forget Europe — weak banks, poor politics and an abject mishandling of the UK and Italian situations. The continent isn’t likely to be a winner from any currency adjustment in China.

Fifth, emerging market equities are not a no-brainer. EMs have been attracting significant inflows this quarter. Yes, EM is cheaper on traditional price to earnings measures — maybe 11 times forward earnings versus 15 times for developed markets. But I am sceptical on earnings growth in 2019. Can EM outperform DM? Yes. Can EM deliver a substantial absolute positive return? Not without less volatility in DM and some clarity on Chinese economic policy. China is the anchor.

Anchors need to be stable. It’s an uncertain world. What should one consider doing? Calibrate duration risk — if one is uncertain about the future, one should be thoughtful about taking duration risk on any asset. Money market funds are yielding 2.5 per cent, now an asset class of its own again.

The government bond yield curve is flat. So, why extend duration? Short term credit yields are also up.

What about private equity? Deals are pricing north of 11 times Ebitda versus 9 times in 2013. The leverage loan market has been under pressure this quarter, leaving banks stuck with loans they can’t syndicate and leveraged loan ETFs and funds are seeing redemptions. Financing is becoming more expensive. You should think hard before committing funds for 20 years at this point.

Venture capital valuations are very extended relative to 2003 and 2008 as well.

Private Credit has been a great story for the best part of the decade. Quantitative easing was its rocket fuel. But I would prefer credit special situations strategies at this point for instance, focused on dislocations in the corporate bond market that are bound to occur.

If you want exposure to equities, stay passive. You may know the odd good active manager, but otherwise passive is best. Such funds have faced much opprobrium, but why lean back towards active management where there is no assurance of outperformance.

On the commodities front, I would recommend owning some precious metals. If there is deflation in asset prices, such securities will outperform.

On the macro front, watch for two things. As mentioned, there is a potential currency adjustment from China, which would be negative for asset prices. I would, however, be long Chinese stocks in anticipation and thereafter.

The other is the Fed possibly slowing its tightening of monetary policy. With $11tn of dollar debt outstanding outside the US, any move that improves dollar liquidity will be bullish for risk assets.

I would be less focused on reading the tea leaves on the next move on interest rates, and more on the possibility of the Fed slowing its quantitative tightening that is running at $50 billion monthly.

This is not a time for a market investor to think long term. There are too many unknowns. The retort will be you can’t time the market. Perhaps, but you can recognise uncertainty and you can be patient.

We all want the bad times to be short and good times to be extended. But don’t expect 2018 to be an aberration. The good times are on hold until further notice.


Nikhil Srinivasan is CIO of Partner Re