We write on this in many Insights, so we will sum up our views here.
USD strength to continue. The USD has rallied nicely against many emerging and developing countries’ currencies. Short-term it may give some of this back, but we expect a much stronger dollar over the next few years. After that, we should see some major weakness in the greenback, driven by lower rates and QE returning. The dollar strength will be driven by a number of primary forces, in our view. Firstly, by tighter liquidity and higher rates in the US and the return of capital abroad. Then it will be driven by the flight to safety. After that, the printing presses will start off again.
Higher Volatility: the last few years of low volatility has been an anomaly and the higher USD and strains in the market are likely to cause major spikes in volatility.
Tighter Liquidity: part of the reason for the stronger USD is driven by rates increasing in the US but also Quantitative Tightening, which is withdrawing some USD500bn per annum. Other major developed market central banks are still stuck at zero, but with inflation rising there is a need for them to start tightening as well. Certainly, there is less liquidity than a few years ago.
We are close to the end of the current business cycle: Yield curve inversion, low unemployment, consumer sentiment and various indicators would indicate we are close to the end of the current business cycle. We are likely also in the midst of the final stages of the of the debt super cycle. Debt levels have risen globally after the financial crash in 2008. There has been a massive shift of debt from the private to public sector in the US but this is not the case in other markets. The debt super-cycle kicked off in the 80’s, with debt levels rising since then.
Long-end of the US yield curve unlikely to move much higher: The 10 year rose to 3.25% and then fell marginally back. We expect the yield curve could reach 4%, but is unlikely to go beyond that, if even past 3.5%. This is still relatively low compared to history, but inflation is still relatively benign. The US economy and housing market are still relatively sensitive to yields and mortgage rates of 5%+ will start to put a severe dent in the housing market.
Inflation unlikely to get out of control before the end of the cycle: Inflation has levelled off at around 2% and benign wage inflation continues to surprise pundits. The reality is that the participation level is still relatively low and so there is room for the workforce to grow, putting less pressure on wage inflation than one would normally expect. While tariffs will be inflationary, we expect the CNY to weaken further so the effect should be more or less neutral, if not slightly deflationary.
The Fed will continue to raise rates: they will do so to get back up to a neutral positioning to contain the potential of an inflation breakout but perhaps more importantly to provide them with firepower in the next slowdown. We have had business cycles and we will continue to have them.
Geopolitical tensions expected to worsen: what we are seeing in terms of the ‘trade war’, is just the start of the transition of dominance, of one super power to another. We can for sure expect tensions to escalate within trade, reserve currency status and militarily. We hope these tensions do not result in war but is likely that smaller wars will be fought as proxies.
Equities short-term: US equities likely marginally higher into year-end as the underlying economy still remains robust and there are few immediate forces to push it lower. Margin levels are high but investor sentiment is not that bullish which usefully indicates we are not at a top. That said, it all depends on investor perception of next year and the rate at which ‘bubbles’ blow up in the international market – such as Australia, Turkey, Argentina and parts of Europe (Italy).
Equities over next few years: will very likely sell-off globally as the business cycles weakens. The depth of this sell off will be dependent on the policy response to it. While our base case is that it could be fairly mild, a change in government in the US and elsewhere could see a major shift in policy. The policy response may be lagged, or it could be redirected to support individuals while institutions are left to fall.
Assuming the policy response is as expected, we would see a rally in gold and other commodities and a repeat of much of what we saw in 2008. This time though, we would be starting from a much higher debt and deficit level, so while economic growth would pick up, we would envisage an eventual cancellation of the debt between the central banks and government which should be inflationary. That will be necessary to offset the deflationary forces in the US caused by aging baby boomers.
Emerging markets and China equity markets likely to remain weak near-term. China’s market is already in bear territory being down over 25% YTD and it looks like a repeat of 2016, when emerging markets underperformed. What will turn it around will be greater liquidity, but the trade tensions and the level of mal-investment is likely to maintain the downward pressure for a while longer. China is though likely to provide a lot of liquidity, which will drive the USD higher in relative terms, putting pressure on other markets and causing a general sell off in Asian related currencies, such as the MYR.
Bonds: US sovereign bonds may weaken a little further, but are likely to be the place to invest over the next few years. We expect yields to move a little higher but when we have a market slowdown, the usual same flight to safety will drive US sovereign bonds higher. There are those that expect yields to go much higher during such a phase, on the expectation of QE, but this QE will be used to buy the longer-dated bonds, thus driving yields lower. We would always hedge this position, by holding gold.
Commodities: likely weaker through to the next market sell off and then much stronger. We see gold and oil being the two most interesting commodities to hold currently. Other commodities are more related to industrial growth and with China slowing, demand is likely to be weak. With QE coming back on line during the next sell off, and a general lack of new capacity coming on stream, we do expect much higher commodities with a 5+ year outlook. We can find some very cheap commodity stocks and will look to take exposure here, as we start to see a floor in prices.
Alternatives: we currently like the space but manager selection is critical. Longer-term, once we see much better valuations in the equity space, we will shift our allocation and go underweight.
In the Alternatives space, it doesn’t pay to invest in the Index or a basket of managers. Selection is absolutely critical to generating strong returns. Most investment managers are struggling with the current environment. Our core FoF account, which is primarily focused on Alternatives, is up around 2% YTD. While this is ahead of most indices and is delivering performance in line with global equities but at much lower volatility, we are still somewhat annoyed that it’s not better. We have a few managers that are massively outperforming, with one up over 20% YTD and a few others up over 6%. Managers in the equity long/short and macro spaces are, however, not performing at the moment but this will likely turn around as their strategies start to work.
In conclusion, we remain largely fully invested but are slowly adding to US Sovereign Bond exposure where we are currently very Underweight. We maintain exposure to a few fixed income managers that provide excellent diversity and are currently short duration. We will look to stock pick around the core portfolio, which remains skewed towards Alternatives. We don’t like Event or Private Equity strategies at this stage in the cycle, but rather managers that can hopefully minimise drawdowns (Equity Long/Short) and play the higher volatility and market moves as they play out (risk arb and macro managers).
Investors should enjoy periods of heightened uncertainty and higher volatility. That’s where the best returns can be generated and active managers can prove their worth. We hope the next few years will treat all readers well.
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