The Rearview Mirror – January 2019. The recent price action: an alarming signal or a source of opportunities?

Blog of markets and finance edited by Christian Zorico

January: 2019 is following the recent price action: an alarming signal or a source of opportunities?

At the beginning of 2018, most market participants were forced to get excited after a spectacular rally of US stock indices, essentially driven by the positive expectations generated by the Trump Tax reform.

However, the reality of performances is well-known. In fact, for asset allocators, there was no place to hide. At the end of the year, almost none of the main asset classes provided a positive return. This was mainly determined by a combination of several factors:

  • From a macro-economic point of view, we had a picture of slower growth, higher inflation and tighter monetary policy.
  • In addition, margin compression combined with growing concerns about the sustainability of corporate debt, played a negative role that triggered a general re-
  • Political factors such as the tariff battle between the US and China and mounting populist pressures in several Countries have contributed negatively to the business sentiment.
  • The Italian debt situation, its political strategy to address the problem, sent an alarming signal to investors who immediately grasped the less incisive role of the ECB in price formation.
  • Last but not least, as we have already highlighted, outflows no longer support risky assets. In essence, we seem to be dealing with pure deleveraging rather than a simple “risk-off” mode.

And what about this year?

No crystal ball can help us, but we endeavour to highlight the aspects which characterise the current situation to better identify if we are approaching a late cycle, thus using our results to calibrate a prudent asset allocation which would fit our main scenario.

It is reasonable to assume that the upcoming months will be influenced by peak sentiment, positioning and poor liquidity. Credit spreads have already widened and P/E multiples have contracted so far. Market mood flirts with uncertainty.
Therefore, the best scenario remains one with a mix of economic data, leaving the FED the opportunity to maintain an accommodating stance.
The market may experience a very volatile environment in rates and exchange rates, but a weaker dollar could help trade balances in some Emerging Countries, dissipating the risk of a large contraction and recession.

In terms of asset allocation, cash is the king. Not only because illiquid assets will remain under pressure, but also because a further decline in the valuation of equities, few emerging bonds or sector selective paper issued in the HY space could represent an opportunity to buy.
In terms of region, the growth differential should return in favour of EM and, as we have already said, a relatively weaker dollar should also support commodities’ price action.

What about Europe?

Again, the uncertainty generated by political concerns and falling operating margins may limit EPS growth. Thus, what may seem like a value story at first glance could be reversed into a value trap.

Value stocks may also represent a potential trade vs. global growth stocks and in any case defensive sectors with positive earning revisions may generate outpacing performance.
Clearly, in this environment to be invested in companies with moderate leverage is wiser; since we could expect an higher rate of default, a prudent allocation can focus on senior paper of Financial and hybrid bond issued by companies with good results’ visibility.

Last but not least, the Energy sector is an historic late cycle performer; current valuations are low, while revisions breadth in many cases is better than expected and sub-sectors such as refiners can benefit from the new international marine standard. From the beginning of 2020, all vessels will be forced to burn low-sulphur diesel instead of heavy fuel oil. This will increase demand for diesel and boost refining volumes.

To sum up, another year characterised by higher volatility can be expected. Generating alpha could be all but an easy task, especially for long-only strategies. The role of hedging or the implementation of relative strategies can play a very important role.

 Christian Zorico: LinkedIn Profile

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