Was the Q4 Sell-Off the Beginning of the End?

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The year 2018 will go down in the history books as one of the most challenging we have faced in recent times, with price action in the fourth quarter being particularly brutal and difficult to respond to. When we wrote our outlook for 2019 at the start of December, we were reasonably cautious and felt it possible that prices could dislocate from fundamentals during the year, if markets started to price in the increasing likelihood of a more meaningful downturn or recession in 2020. We were not expecting this to happen in December, but it did, and it has left investors wondering whether this is the beginning of the end of the cycle, and whether months like December will be commonplace in 2019.

The cause of this, as we wrote earlier this week, was fear of a globally coordinated slowdown coupled with the growing expectation of a Fed policy error. Last Thursday’s US ISM data seemed to confirm the market’s bear case scenario, and hence the New Year began where December left off. However, on Friday we then had the very supportive US employment report and a Fed chair forum, in Atlanta, that poured a lot of cold water on the bears; this has been compounded this week with Fed speakers reeling in the possibility of further rate hikes unless the fundamental data warrants otherwise. As a result, the probability of a Fed policy error has been materially reduced.

If a policy error is less likely, that just leaves us with slowing growth, and in some geographies that has been more severe than others. The question investors need to answer correctly, is whether this is the beginning of the end, or just another one of many intra-cycle dips that we have seen before in this elongated recovery.

Our view is that we are just experiencing another dip, as uncomfortable as it may seem. We were certainly concerned about the Fed hiking blindly towards a neutral stance that could be several hikes down the road, but that risk has dissipated. The huge amount of data that is released on a daily basis is just not indicative of anything more sinister at this juncture.

This thesis is supported by all the major central bankers around the world, and they have access to more data than the average market participant. Similarly, I would have expected to hear negative rhetoric from the major commercial banks in the key geographies if a more aggressive downtown was looming, but instead we hear a consistent story of still healthy financial conditions. In making the decision that this is an intra-cycle dip, we also feel that a hard landing leading to a nasty default cycle is currently unlikely. That said, we do acknowledge the lessons learned from Q4, which tell us exactly how the market will behave when we do eventually get to the cycle’s end, and investors would be wise to recalibrate their portfolio stress testing based on the Q4 experience.

All prior dips in this cycle have been a good opportunity for investors. The best example is the second half of 2011, when assets became extraordinarily cheap again and risk taking was very well rewarded. Another good opportunity came after Bernanke’s taper tantrum in 2013, but valuations only supported a moderate risk increase. Then of course we had Q1 2016, which is being likened in many aspects to where we are now; here valuations became very cheap and risk taking was again well rewarded in the aftermath.

Today’s dip opportunity is less clear cut and while valuations are better, they are not extraordinarily cheap and there is a lingering fear that the cycle must surely come to an end soon, making positioning this buying opportunity tricky for investors. It is in times like these we are fortunate to just invest in fixed income markets, where bonds mature at a certain point and we can place our risks in a time frame that we are comfortable with.

We think a small amount of extra risk taking is merited at current valuations, and have been adding very short dated credit bonds to our strategies. By very short we mean bonds that mature before any potential trouble begins, or ones that are so short the yield trumps the mark-to-market stress tests we subject them to. It’s pretty boring compared with prior dips, but this is all we think is on offer currently. Note that we are not saying there will not be a repeat of such episodes, only that the ingredients of the previous dip have now played out.

We would also point out that we feel investors probably still own more risk than they would like, meaning rallies like we are seeing now are still likely to be met with selling as investors find their new points of comfort.

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