Policy makers have pressed pause

The three concerns that were dogging markets not so long ago were supposedly higher US rates, a plummeting oil price and the US-China trade war.

Taking those in turn, the US Federal Reserve clearly signposted that they were moving from being date-dependent to data-dependent, which is probably a sensible move in terms of where we are in the cycle. Interest rate rises being date-dependent served a purpose in the initial QE exit phase, to help reduce uncertainty around US monetary policy more broadly, but time has moved on and being date-dependent had to end at some point.

Markets have since priced in a much more dovish rate cycle, and this makes some sense too. The latest US economic activity surveys look strong but interest rate sensitive sectors, like housing, are slowing, domestic financial conditions are tightening and the global economy has been slowing for some time too (the US is relatively self-reliant but doesn’t operate in a complete vacuum).

Meanwhile, the oil price has stabilised after its sharp fall lower and two key actors, the Saudis and the US, have suggested they are comfortable with these levels. Additionally, a 90-day truce in the trade war has been declared between the US and China.

Stepping back, this environment underscores the broader move we have been talking about for some time. Markets have moved away from being dominated by central bank policy makers, to being dominated by political policy makers.

But what has been the reaction from markets to having these concerns put on ice? In short, they have continued selling-off. In fact, markets have simply turned to focus on new risks, for example the aborted parliamentary vote on Brexit.

So, maybe it’s not these concerns per se, but rather that markets are just focusing on risk more. Maybe it is the slow grind of quantitative tightening in the background, in crude terms, just acting in reverse to QE. This is leading to the “survival of the fittest”, but what has this meant for asset classes?

With the benefit of hindsight, despite a broadly positive macro environment since the beginning of February this year (when markets started to sell-off), it has been a fairly textbook response to risk-off. Within equities, defensives have outperformed cyclicals (see graph). Within bonds, US Treasuries bonds have outperformed US high yield corporate bonds, within commodities, gold has answered its safe-haven calling, and within currencies the traditional safe havens of the Japanese yen, Swiss franc and the US dollar have outperformed most other major currencies.

Defensives have outperformed since May this year

Source: Bloomberg, 29/11/2013 – 03/12/2018.

Importantly, that’s not to say that these risk-off assets all made positive gains, but they did generally outperform risk-on assets. So, just because they were the better place to be, doesn’t mean they preserved capital.

Looking forward, this raises two questions, for how long will markets be driven by risk-off characteristics and will the market continue to be driven by textbook responses? Risk-off sentiment feels fairly embedded but, without stating the obvious, at some point that will turn. Meanwhile, until markets signal otherwise, we would expect a fairly textbook response to continue. More generally, we expect geopolitics to continue to dominate and quantitative tightening to produce a more demanding environment generally. As such, we continue to be broadly defensive but with an eye to opportunities.


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Source for information: Miton as at 12/12/2018 unless otherwise stated.

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