Outlook 2019 - Riding the risk/reward seesaw

  • 24 Dec 2018

    Return of capital will take priority over return on capital for investors, as global monetary policy continues on the path to normalisation.

    1. What is your investment outlook for 2019?

    Despite signs of ageing, US growth momentum remains above its long-term potential, with robust employment conditions compelling the US Federal Reserve to push ahead with interest rate hikes into next year.

    Subject to resolution of Italian budget wrangling and the absence of a populist wave in the May 2019 European Parliamentary elections, the European Central Bank (ECB) should begin to follow suit and take its next step on the journey back to traditional monetary policy.

    In Asia, Chinese authorities should continue to walk the tightrope of reducing undesirable forms of leverage, while simultaneously releasing liquidity pressures in the financial system.

    The implications of these measures may prove bittersweet for fixed income investors. On the one hand, any dislocation in emerging market growth and credit cycles could create asset allocation opportunities, however returns should remain correlated with USD strength and resulting capital flows.

    Smooth implementation of policy measures could push potential recession risk further into the future and spell lower defaults in the coming year. In that scenario, with credit spreads offering more cushion than previously, a diversified portfolio of credit spread securities has the potential to insulate investors against the headwinds of rising risk-free rates over the course of 2019.

    2. What do you think could most surprise investors next year?

    Following the Italian elections, investors have recently become reacquainted with the concept of European systemic risk, but so far at least, contagion has been limited. Nevertheless, the market-implied assumption is that any further polarisation of views in this respect could lead to greater spread widening and another leg higher in volatility terms.

    In parallel, the intensification of trade war rhetoric and its impact upon European economies appears to have reinforced perceptions that ‘lukewarm’ potential output is the best the continent can do.

    While in the long terms that remains most likely (in the absence of meaningful structural reform), few investors envisage that both a successful resolution of the Italian budget drama and an easing of global trade tensions can materialise.

    However, if that path clears, the ECB may hasten to higher policy ground much faster than markets currently expect. Rapid shifts in policy differentials would then trigger meaningful adjustments in currencies, rates and valuation multiples. By all means a tail risk in our view, however a scenario that is all too easy to disregard, as many investors begin to fixate on the possibility of global growth receding.

    3. How do you plan to capture the best opportunities?

    In the near-term, we remain cautious on duration-sensitive securities, as the path of least resistance for global interest rates still seems to be higher in our view.

    We retain a more positive view on higher spread assets, which - notwithstanding an increasingly fragile backdrop - remain suitably placed to potentially deliver positive excess returns in the coming year. Credits that have sufficient buffers to avoid capital market access for the next 12-18 months should also command an increasing premium.

    More regular bouts of market turbulence should also continue to present short-term tactical spread compression opportunities which, perhaps more importantly, should create better conditions for further improving portfolio credit quality in 2019.

    Lessons learned over past credit cycles, with respect to accessing liquidity and managing drawdown to preserve capital, have guided us to move in advance of a cyclical inflection point, rather than holding low conviction, more levered exposures through the next trough.

    And with the yield dilemma facing investors still very much in play across developed markets, the aim of our unconstrained, income-focused strategy for 2019 is to capture ‘quality yield’ in a risk-efficient manner, rather than simply ‘yield at all costs’.