Industry Voice: The story so far for 2019 has been the dramatic recovery in risk assets, with the S&P 500 producing a year's worth of returns in four weeks. But does this mean the party is back on after a period of overselling in the late stages of 2018?
A change of tune
There is no doubt that prices have rallied hard since the beginning of the year, but we have seen limited improvements in the key fundamental drivers of markets. The US dollar is flat on the year, US real rates have decreased by a small margin, and the oil price has spiked by more than 20%. This combination of factors is unsettling against a backdrop of renewed bullishness.
Trading activity in the Open Range in recent months reflects the unfolding story. After having hedges on risk for much of the final quarter of 2018, we bought back some risk in December by closing short positions in Korea and Japan, and re-cycling some exposure from defensive US utilities into the S&P 500. More recently, we have taken some risk back off the table after the rally in January. This reflects our concerns that fundamentals are not keeping pace with the market.
If investors were truly convinced that we were back on a risk-on footing, hedging assets such as gold and US Treasuries would have performed poorly so far this year. But that has not been the case, and there is evidence that market participants aren't fully on board with the risk rally as both defensive assets are more than holding their ground. We have maintained a healthy exposure to these and other hedging assets that should perform well if markets come under a renewed period of downward pressure in the coming months.
The equity market has rallied
Source: Refinitiv, February 2019
Risky business?
We do see pockets of opportunity beyond risk-off assets, however, and are prepared to take positions as and when they arise. One area that has performed strongly in the new year after taking a battering in 2018 is the emerging markets complex, with the traditional buy signals for the space beginning to rise to present themselves - namely a Federal Reserve that has hit the pause button on its tightening cycle, and a US dollar looking unlikely to continue appreciating as it had in 2018. Combined with attractive valuations after a rough 2018, we believe that emerging markets equities and debt are offering up some attractive opportunities, but maintaining selectivity is important given the wide dispersion between regions and asset classes in this heterogenous space.
Moving to the beat
In order to take advantage of the price action within regional markets at present, we are not removing hedges in the Open Range, but are rotating within risk assets instead. We characterise our positioning as cautious given the recent re-rating of risk assets to the upside, and are closely watching corporate earnings growth as a proxy for the direction of growth expectations. While the dovish stance taken by the Federal Reserve has calmed the waters for now, markets may have to force a more robust response from the authorities if growth slows. Many investors seem content to assume that the trajectory of growth won't falter - but we are not so sure.
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