Repricing across all major asset classes, which is to be expected during times of rising interest rates, is happening with a vengeance since December. Indeed, the current market environment can shake the confidence of any investor. Headlines about US government turmoil, rising interest rates, trade wars, and falling asset prices combined are enough to test anybody’s resilience. In our view, markets are pricing in two key factors: 1) rising interest rates; and 2) concerns for economic growth going forward.
As the Fed has continued to steadily increase its target interest rate (now 2.25% – 2.5%), capital markets are justifiably adjusting to higher, more competitive yields on risk-free investments, such as Treasury money market funds. It makes sense that since investors are earning 1 percentage point more on cash than one year ago – and nearly 2 percentage points more than two years ago – they would increase their expectations for riskier assets. We think some of this repricing can be healthy given the extremely low market volatility experienced in 2017 (and prior). Further, the Federal Reserve will continue tightening monetary policy only if they feel US economic growth is robust, which it has been. However, recent market turbulence may force the Fed to back away from its stated goal of two more interest rate increases in 2019.
That said, when one combines an increase in the risk-free interest rate with uncertainty regarding global growth, the recent asset price adjustment can seem extreme. However, current market moves, while painful, are not yet at extreme levels; remember that the equity market posted double digit returns in 2017. That is not to say that we are not concerned. In looking back at our first quarter outlook for 2018, we highlighted interest rates and trade wars as key concerns for 2018, but we did not expect the current level of government turmoil, particularly in the US and Europe.
Regarding that, we think Fed Chair Jerome Powell’s seat is secure despite the current administration’s bluster, and the recent unnecessary confusion caused by the US Treasury Secretary’s review of bank stability. In Europe, political risks are increasing, namely Italy’s budget rift with Brussels, which seems to have been temporarily resolved, and most importantly Brexit, for which only the March 29, 2019 deadline is clear at this point. Finally, negotiations between the US and China seem to have broken down, although trade friction seems to be priced in more today than a year ago. Combined, these issues are causing market participants to reprice expectations for the future in the face of current solid economic fundamentals.
What We Are Doing
We have already begun positioning LNWM client portfolios to reflect a higher-risk environment. These moves, which we will detail in our Q1 2019 Economic Outlook (published in mid-January), will allow us to capitalize on the nearly 2.5% yield for shorter-term fixed income instruments while maintaining some “dry powder”” for future opportunities.
In terms of new opportunities, valuations have certainly cheapened across the asset classes. Large-cap US equities, for example, are now trading at less than 15 times earnings estimates for the next 12 months, which is in line with historical averages and much lower than earlier this year. At the same time, the balance sheets of large, high-quality companies remain strong. While we are encouraged by more attractive valuations, we do recognize the susceptibility of pricing to earnings downgrades. We think stocks and other types of riskier assets would benefit from a US-China trade agreement and clarity from the Federal Reserve regarding the future path of rate increases, although it is very difficult to predict either of these at this time.