Ten years into the longest bull run in history and major dislocations are starting to appear, characterised by bouts of volatility across global markets. And while central banks have indicated they are watching closely for signs of wage inflation, the market is notably complacent about rising prices. Safe havens in the form of US inflation-linked bonds are growing in attractiveness as a result.
Meanwhile, we are optimistic about the direction of travel for equities in 2019, but it is prudent to exercise caution. At a technical level we have not yet seen the levels of irrational exuberance that would indicate the end of the bull market, marking a particularly positive signal for value stocks over the hotter growth names. We retain a neutral view on equities through periods of volatility, cognisant of the fact that it is rarely a good idea to change positions in moments of short-term market turbulence. Overall the outlook is for an unsettled market environment, within which we would look to alternative investments as providing a source of steady uncorrelated returns.
In 2018, inflation has been subdued despite healthy economic growth, particularly in the US. But we expect that to change as commodity price increases feed into the system, and the negative output gap starts to push up wage costs. As a result, we expect US inflation to continue to rise throughout 2019, beyond the Fed’s 2 per cent target.
While our base case is for a moderate increase, the biggest problems in markets often go unnoticed until it’s too late. Higher-than-expected inflation is one of those potential problems. We haven’t seen inflation run unchecked in developed economies for several decades, leaving many convinced that central bank independence has tamed it for good. These are fertile conditions for complacency, and there is a real risk of inflation spiralling if central banks pull back from further monetary tightening, fearing a market backlash.
US policymakers would be able to justify a short period of above-target inflation by taking a multi-decade perspective. Levels of up to 5 per cent could be tolerable if seen in the context of the past 10 years of low inflation, and might well be regarded as preferable to overtightening which risks choking off growth. As result, there is a risk that the Fed falls behind the curve on inflation, which would make monetary policy less predictable and markets less stable. For these reasons, assets that offer inflation protection, such as US TIPS, should do well in 2019 at the very least, and have the potential to materially outperform areas of the fixed income market exposed to rising prices and indeed interest rates.
Chart 1: US inflation on the march
Source: Haver Analytics, Fidelity International, October 2018
While the Fed may battle for control of inflation, the European Central Bank may not have that luxury. Inflation and PMI data have disappointed in Europe, informing our negative outlook for the bloc. We expect downward pressure on the euro, and are negative on European high yield and periphery government debt, for as long as political uncertainty and slow growth define the region.
It is difficult to predict global inflation prospects with accuracy, and gold is a good example of an asset that offers protection in an uncertain market. On the one hand, gold has a solid track record as a hedge against inflation and rising inflation expectations. On the other, it may also perform positively in deflationary environments, many of which are accompanied by sharp declines in domestic demand and broader defensiveness.
The year of the long-awaited rotation
Markets are overdue a change of leadership. The bull market cycle is in its late stages but is not finished yet, and we are cautiously optimistic that technical factors will fuel further stock market gains, even as fundamental factors wane. We haven’t yet seen the irrational exuberance that typifies the end of a bull market, and the cash still left on the sidelines may flow towards companies that have been out of favour in recent years.
We are watching opportunities around cyclical stocks displaying the qualities of traditional value that would benefit the most in this scenario, diverting flows from the narrow group of technology stocks that drove the market skyward for much of 2018. That said, we are wary of falling into value traps, particularly when it comes to financial stocks. The exciting growth story around names such as Amazon and Netflix has caused a noticeable price dislocation between companies the market perceives as interesting and those seen as dull. But it is almost impossible to price a company like Netflix; a company that in 15 years’ time could either dominate the world or be worth nothing. It was precisely a reappraisal of this growth narrative that drove much of the volatility in the fourth quarter of 2018. Through this period we retained a neutral outlook on equities, aware that market participants are prone to over- or underestimate short-term movements in asset prices. Changing positions in a period of short-term volatility is rarely a good idea.
Against this unsettled backdrop, alternative investments that offer steady uncorrelated returns are becoming increasingly attractive. Investments in areas such as infrastructure, renewable energy and market neutral strategies will add an important element of diversification to multi asset portfolios. Overall, while 2018 was a case of staying braver for longer, and 2019 shows promise, we are watching for signs that such bravery may be punished as foolishness if markets turn and are positioning our portfolios accordingly.