TO CHASE OR NOT TO CHASE THE RALLY?

GLOBAL markets have started 2019 on a firmer footing after losses in 2018. We see equities and bonds eking out positive returns this year, and still advocate a carefully balanced approach in portfolios due to late-cycle concerns and ongoing geopolitical uncertainties. We caution against chasing the rally in risk assets, particularly in areas vulnerable to growth downgrades, geopolitical risks or sudden shifts in supply/demand dynamics.

Global stocks kicked off 2019 with a bang – posting their best month in more than eight years. Other risk assets also rallied. A key impetus: a big shift in policy expectations across the globe. Markets have moved from pricing in two 2019 rate increases by the US Federal Reserve in November to flirting with the potential of a cut.

The Fed has pledged patience and flexibility in future rate moves and signalled the potential of maintaining a larger-than-expected balance sheet. Fed policymakers are not alone in sounding more dovish. China has signalled a move to easier credit and fiscal conditions. We are also seeing increasingly expansionary fiscal policy in Europe: Italy and Spain are already ramping up public spending, France has pledged to cut taxes and increase wages, and Germany is considering tax cuts.

Market attention to geopolitical risks has dipped from the elevated levels seen in the second half of 2018. Markets now see a higher likelihood of a limited US-China trade deal. This eases a major source of market angst, though any disappointment could sting more. Some pockets of the markets, such as high yield and emerging market debt, have been supported by lowerthan-usual issuance. Yet such supply/ demand dynamics could change quickly.

Can the risk rally be sustained? The US economy has entered the late cycle. Historically, this has been associated with positive stock and bond returns – and frequently has rewarded risk-taking. Two examples are the late 1990s and 2006, when global equities and bonds both posted double-digit returns. Yet we see reasons for caution.

Late cycles have come with higher volatility in the past three decades, our analysis finds. Nearterm consensus expectations for economic and earnings growth still appear high, even though we view the risk of a 2019 US recession as low. We also see geopolitical risks as a persistent force in markets – with the strategic confrontation between the US and China over technology dominance and threats to European political stability as two underappreciated risks over the medium term. Another factor to consider: financial asset valuations are now less compelling than in late 2018.

Our base case: a modest easing of financial conditions globally is likely sufficient to stabilise growth in the second half of 2019. Any decisive move in global monetary and fiscal positions toward a more growth-friendly stance could trigger a renewed bull market, we believe. Yet we still argue for a carefully balanced investment approach. This includes taking risks where they are being sufficiently rewarded. Cash is less attractive than equities and bonds. Bonds offer slightly higher returns and significantly greater diversification benefits than they did in 2018. We prefer equity over credit, and emerging markets over developed markets outside of the US.