Chief Investment Strategist
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Amid poor year-end liquidity and unsettled global financial markets, the Citi Private Bank Global Investment Committee today left its asset allocation unchanged
Amid poor year-end liquidity and unsettled global financial markets, the Citi Private Bank Global Investment Committee left its asset allocation unchanged on the 22 December 2018. With a tactical return period targeting 12-18 months ahead, global equities remain 1% overweight while global fixed income remains underweight by 1%.
For average risk portfolios including alternative investments, this is a 39% allocation to global equities and 37% to unlevered fixed income. While no panacea for asset market volatility, we believe regionally diversified portfolios diminish local political risks, such as Brexit. Meanwhile, multi-asset class investments with a strong income component appropriately balance risk and reward for long-term investors.
Within our present tactical allocation, US large cap equities remain at neutral, while small and mid-cap US equities remain underweight. US fixed income remains overweight, with a concentration on high quality short-term debt (and municipal bonds across the maturity spectrum for US taxpayers.) European and Japanese government bonds remain a substantial underweight given historically low yields. This creates capacity to invest in non-US equities with solid long-term growth opportunities, moderate valuations and strong dividend yields.
Policy and political risks remain elevated and have hit most global markets in late 2018. US equities are no longer isolated from the impact of weaker growth expectations in late 2018, with trade friction and potential mishaps on the monetary policy front impacting all markets.
Despite movements toward trade accords between the US and the European Union, NAFTA Countries and China, trade-sensitive asset prices have fallen hard and not recovered, underperforming global markets in 2018. This suggests skepticism that a trade war will ultimately be avoided. However, as these are cyclical industries and countries, a generalized weakening in growth expectations now seems significantly responsible for performance.
Global equities have fallen 15% from their 2018 high point while EPS gains have shown consistent growth. Leading indicators suggest a significant slowing in corporate profit growth from 2018, but not a contraction in 2019 (we estimate 16% in 2018 and 8% in 2019). The “disconnect” between share prices and contemporaneous growth readings appears to be the largest in nearly 25 years, when the Federal Reserve first tightened monetary policy unexpectedly in 1994.
The Fed has been a factor in the large, 30% drop in US equity valuations this year (EPS +24%, index prices -6%). This valuation drop raises forward-looking returns. However, the tightening in financial conditions does more in the near-term to raise business cycle risks. We agree with Federal Reserve forecasts that the US economy will manage another year of growth in 2019. However, multiple policy threats to business and consumer confidence are risks that bear close watching.
The Fed raised short-term interest rates yesterday for a fourth time in 2018 and for a fourth December in a row. Prior to the present cycle, late-year market illiquidity has generally been a concern for executing policy actions smoothly. The Fed rarely tightened so late in the year given these concerns.
The Fed’s guidance at its policy meeting yesterday is also problematic. The US central bank reduced its expected path for monetary tightening to two 25 basis point steps for the coming year, from three previously. It noted greater “data dependence” with policy able to respond flexibly. At the same time, Fed Chairman Powell noted that the Fed’s actions to shrink its bond portfolio are on “automatic pilot.”
While Quantitative Tightening (QT) is indeed gradual, it is erroneous to say the Fed’s portfolio actions are not a monetary policy mechanism, as Chairman Powell suggested. The Fed has given no guidance at all for conditions under which it may change its balance sheet policy from a rundown pace of $50 billion per month. The Fed’s intended path for private financial conditions is now in question, adding to other key policy uncertainties.
We see the capacity to finance bond markets and other assets as far larger than the outflows from the Fed’s balance sheet. Poor year-end liquidity and high levels of investor uncertainty across asset classes suggests significant room for a market rebound in the coming year. This is particularly as equity and credit market declines have far outstripped immediate fundamental weakness. However, with the US economy fully employed and corporate profits high, it discourages us from raising US equity allocations. Ultimately, we expect a turn in the Fed’s monetary policy to weaken the US dollar, and benefit non-US asset prices. For the near-term, significant policy uncertainty will likely restrain asset price returns.