Having started October with a feeling of unease, we have seen the backdrop for risk assets going into year-end improve, despite reasonably full valuations.
Our chief concerns were geopolitical risks layered on top of a globally coordinated economic slowdown. Those geopolitical risks – namely Brexit and the US-China trade war – have for the time being at least, not had the negative consequences they could have, and in fact have the possibility of becoming positive risk catalysts going into 2020. In the UK a hard Brexit on October 31 was avoided and now looks reasonably unlikely, and there is the possibility of a more market friendly government post-general election on December 12.
The trade war meanwhile is at least no longer escalating, while both sides have committed to signing a ‘phase one’ deal, which looks reasonably likely. While this outcome would merely avert more negative effects, the positive catalyst would be the rolling back of existing tariffs, which could be a more positive tail risk for markets in 2020. In addition, the major auto manufacturers in Europe and Japan have been in bilateral discussions with the US Department of Commerce, and may well have committed enough US investment to avert another new layer of tariffs.
As bond investors, we were also a little nervous that Q3 earnings season might reveal some of the cracks we had been picking up in the macro picture, but by and large earnings have not disappointed so far, enabling equity markets in the US to make new highs.
The globally coordinated economic slowdown remains a worry, but the rate of slowdown is abating and the less negative factors above may improve business confidence and investment as we head into 2020. The Fed has now executed three rate cuts, coincidentally the same number that previously helped the central bank engineer rare soft landings in 1995 and 1998. The benefit of these cuts, along with an outlook for more stable rather than rising rates, which hurt markets so severely in Q4 of 2018, should support the cycle’s longevity.
Those three rate cuts are also important for investors evaluating cash as an asset class. In most of the developed world, cash rates promote investors moving into assets such as fixed income, but briefly this year US rates crept high enough for investors to consider US dollar cash as an investment again. We think three cuts is enough to have reversed this temporary move, and this should be very supportive for fixed income in particular.
So what might all this mean for fixed income assets going into year-end?
Firstly, the desire to hold ‘risk-free’ rates products should abate slightly, though we do not see rates moving materially higher as investors have had the perfect reminder of how holding these can and does improve a balanced portfolio’s volatility, which we think is a strong desirable late in the cycle.
However, we acknowledge that rates could detract slightly from fixed income performance going into year-end. On the other side of the risk spectrum, the need for safe yield is even higher than it was earlier in the year and investors should be bolstered by the additional safety provided by the current geopolitical calm. Credit spreads are fairly tight but still generally 10%–15% off the tights we saw earlier in the year. It is here where we think a modest increase in risk could be warranted going into year-end.