Equities and corporate credit well placed as fed pauses for breath

WHAT HAPPENED AT THE END OF LAST YEAR?

Theories abound on what drove profound weakness across asset markets in the final quarter of 2018. Although losses were similar, or in some instances deeper than they were in the throes of the global financial crisis a decade ago, the macroeconomic, earnings and policy backdrop was, and remains, remarkably distinct. For example, both experienced and expected economic growth and earnings last year were decent, at or above respective trend rates.

To our minds, the chief culprit of torrid market returns was a rolling, global discount rate shock, which began in October with rising nominal yields, then real yields, and finally a jolt wider in credit spreads. Fixed income and equity markets were strikingly “joined up” in derating; by the end of the year asset markets collectively appeared to be pricing around a 60% chance of economic recession. This was not our expectation and as such, late 2018 and early 2019 offered us a good opportunity to build exposures in favoured assets at a (much) cheaper price.

WHERE DOES THIS LEAVE US IN 2019?

The sharp tightening in global financial conditions delivered by this market behaviour had another important consequence: it gave the Federal Reserve an opportunity to pause. Insofar as financial conditions are the key mechanism through which the Fed influences the real economy, these tightening conditions allowed it to take a temporary step back. And, just as the Fed paused, economic and earnings data started to soften.

This creates an interesting set up for 2019. The Fed pause led to a sharp relief rally in risk assets in the early months of the year, soaking up the losses/premia from the fourth quarter of last year and unwinding just over half the tightening in financial conditions that occurred over that period. Policy stimulus from other countries, like China for example, has also been helpful. Yet should conditions ease more meaningfully in the US – an economy that is operating at or through full employment – it would not surprise us to see the Fed back in play.

Our economic and earnings forecasts for the next 12-24 months point to a transient soft patch rather than a meaningful slowdown; notwithstanding geopolitical risks, most regions are projected to recover to, or slightly above, trend growth, supporting decent mid-single digit earnings growth across most. Equities, and increasingly corporate credit, look well placed to benefit in this environment, and we take exposure to both asset classes in the global multi-asset income fund. Long duration core fixed income, by contrast, looks particularly vulnerable, and we run the fund with light overall duration of 1.6 years to reflect this view.

WHAT HAVE WE CHANGED OVER RECENT MONTHS?

The Global Multi Asset Income strategy seeks to deliver attractive levels of income, with volatility control, by investing in equities, fixed income and writing of covered calls. With this objective in mind, and in the context of the above, three things have changed in recent months:

First, we have taken the opportunity to be more active in our management of covered calls. As a seller of call options, the GMAI fund can benefit from periods of higher implied market volatility. Certainly, in each of the volatility spikes in recent months we have been able to move further out of the money and still harvest greater-than-usual income from our covered call sales. As such, the covered call aspect of the strategy provided protection in weak and volatile markets, contributing strongly to income gains and allowing our investors to participate in rising markets.

Second, we have increased our exposure to Asian equities. This was an area where significant risk premium opened up last year, suffering a perfect storm of concerns around a China slowdown, fears of escalating trade wars and a softer global macroeconomic backdrop. We were, over the course of December, adding to our Asian equity position through the TLux Asian Equity Income strategy. On a look-through basis, the fund has about 5.5% in high yielding emerging market Asian equities.

And third and finally, as explained in some detail in our February Asset Allocation update, Much ado about equities and credit, we have marked up credit to favour, bringing it in line with equities.

Although slowing but positive economic and earnings growth supports our continued holding of equites, corporate credit is looking increasingly interesting to us – and in GMAI we have taken the opportunity to add 3% to our European high yield position, funded from equities, and top up our holding in short-dated EM hard currency bonds through SXGEMS.