A Better Deal
Aura believe 2019 offers a better deal for investors for three key reasons:
1. Continued expansion in global growth and corporate profits. We believe US growth will moderate in 2019 while the slowdown outside of the US is now behind us. Many Emerging Markets economies remain in the early stages of recovery with room to run. In our view, the continued global expansion will underpin corporate earnings growth and support risk asset performance.
2. A low bar for positive surprises. Conditions heading into 2018 were hard to beat, resulting in a situation where most surprises were negative. That is not the case going into 2019. Macro expectations and asset prices have adjusted sharply lower, lowering the bar for positive surprises that could lift asset prices.
3. Attractive valuations. In our view, the significant shift in valuations in 2018 is overdone relative to both macro and corporate fundamentals. Investors concerns around the long cycle, trade tensions and populist politics will likely carry through to 2019, but we believe it is too soon to position for the end of the cycle and markets have already gone too far in pricing these risks.
Navigating the Cycle: Pro-risk or de-risk?
Aura believe it is too soon to de-risk
2019 will likely see increased focus on the end of the cycle. We think clearer signs of deterioration are required before de-risking. We do not expect to see those signs in the first half of 2019, though risks will rise as the year progresses.
1. The late cycle environment may shape markets. Historically equity volatility picks up toward the end of the cycle and we think we saw the trough in late 2017. The next major market event on the historical template is a trough in credit spreads. We think it is too early to position for this but will be watching credit markets closely in 2019. There is also a historical correlation between Aura & US Treasury yield curve flattening or inversion and recession. But a decline in term premium may have changed this signal and so we think it is more important to focus on economic data.
2. The macro backdrop suggests it is too early to de-risk. Economic growth is slowing but still growing and the rise in core inflation is steady not speedy, while central bank tightening is gradual not rapid. Additionally, corporate profit margins are still expanding and financial imbalances pose idiosyncratic rather than systemic challenges. As such we think it is premature to de-risk and we remain pro-risk.
3. But it is not too early to improve the trade-off around any take-down of risk. We think risks around late-stage cycle traits, including contracting corporate profit margins, excessive central bank tightening and systemic financial imbalances, will rise as the year passes. To prepare for this, at the micro level we favour exposure to companies with strong pricing power and on the macro front we prefer early cycle economies.
How far will the Fed go?
We expect three Federal Reserve Bank rate hikes in 2019 but risks to our view are balanced.
The Fed has been steadily tightening monetary policy for two years. A key question for investors—and a key consideration for risk assets in 2019—is whether that gradual tightening continues.
1. We have less conviction on the Fed outlook for 2019. For the last two years, we have had high conviction that the market was underpricing the path of Fed rate hikes. We think that is still the case, which underpins our expectation for further increases in market interest rates, but we have less conviction in our Fed view compared to 2017 and 2018.
2. Risks to our Fed outlook are balanced. With the recent tightening in financial conditions and next year’s expected growth slowdown, we think the case for a pause in the Fed’s tightening campaign has grown stronger. We also see a risk that wage and price inflation pick up in 2019 given the tightness in the US labor market, leading the Fed to continue hiking every quarter through 2019.
3. We see the Fed’s path as critical for risk assets. The Fed is both creating and responding to changes in financial conditions. If financial conditions continue to tighten primarily due to a cheapening in equities, we do not see that as a compelling reason for the Fed to respond or for investors to de-risk. If financial conditions tighten due to a rise in long-term interest rates, we think the Fed may pause to assess the medium- to long-term outlook, which could be supportive for risk assets. As a result, we think the main downside scenario for risk assets is that economic growth slows but rising inflation forces to Fed to continue hiking.
Where are the investment opportunities?
We believe valuations are attractive relative to fundamentals
We prefer equity over credit, and credit over rates, and regionally, EM to DM. These preferences are based on attractive valuations relative to macro and corporate fundamentals.
1. Equities are our preferred asset class. We think the 2019 risk-reward for equities is improved relative to 2018 after the de-rating in valuation multiples observed this year. Selectivity is increasingly important amid higher volatility, elevated political and trade risks, as well as slowing revenue growth and margin pressures.
2. Recent underperformance has created attractive valuations in corporate credit. Continued economic and corporate earnings growth may help to keep downgrade and default activity in check, while also affording over-levered issuers time to potentially improve credit quality. We favor exposure to issuers with strong or improving balance sheets, high interest coverage ratios and pricing power (given rising input and wage costs).
3. We expect renewed outperformance of EM assets relative to DM. EM asset devaluations—particularly in currencies and equities—have surpassed what is implied by underlying fundamentals. In 2019, we expect EM asset performance to be unleashed by improving growth and upside policy surprises.