Various short-term excesses began to resurface in markets in January. Luckily, the sharp correction that ensued provided the overdue cold shower, which should help cool expectations, bring prices more in line with fundamentals, and thus prolong the bull market. As our macro view remains positive, we used the rout to put some of our cash back to work.
Our quarterly tactical asset allocation review (QTAA) in December and our Annual Outlook in January acknowledged a robust macro outlook, characterized by increasingly self-sustained growth in nearly all economies and subdued inflation in most. However, concerning the financial markets, we were wary about some emerging signs of investor complacency and exuberance - i.e. the typical phenomena of the later stages in any bull market cycle.
Consequently, despite the positive macro backdrop, our December QTAA adopted a defensive bias: we replenished cash reserves by trimming our then pronounced overweight in equities to only a modest one, reduced emerging markets (EM) in the fixed income segment, and raised hedge funds back up to our strategic quota.
Similarly, in our full-year outlook we advised investors to sharpen their focus on fundamentals and the quality of investments - and to prepare to respond to opportunities when markets move in extreme ways. By early February, our concerns had proven correct and the first global selloff in years wiped out most of January’s equity market gains (graph 1).
Fortunately, the market rout of the past couple of weeks has corrected many of the potentially self-destructive market excesses, making us more comfortable with aligning our investment strategy more closely with our macro views. We have thus reversed some of December’s moves by drawing on about a third of our cash reserves to increase equity positions in the US and the EM (these were the two markets we had sold in December).
The US is where the recent build-up of short-term excess had started to accelerate most, right after the passage of the US tax reform package in late December. The recent selloff took prices too far down in our view, given the positive current macro environment. The EM, meanwhile, are among the markets that remain more attractively valued, face a less challenging interest rate outlook, and had dropped least during the turmoil. In short, both markets became more attractive for different reasons. The EM remain supported by both technical and fundamental factors, while the US is where the correction created short-term opportunities.
The business-friendly narratives surrounding US President Donald Trump’s tax reform package had evidently played a role in firing up expectations too much, too quickly.
To be clear: this is not to say that the tax changes will not have a net positive impact on corporate earnings in the US - they will. The problem lies with the pace and magnitude of the shift in expectations, not the fact of the improved outlook per se. The main challenges in navigating late-cycle bull market arise when market participants’ expectations start to take off, which inevitably leads to disappointment at some point in the future. In this context, the following developments stood out since our last QTAA in early December:
Luckily, the selloff has started to correct these potentially accelerating imbalances - or at least put them on a more reasonable path.
Note: The next edition of the LGT Beacon is scheduled for mid March 2018.