A tough act to follow?

written by Mark Haefele, Global Chief Investment Officer, UBS Global Wealth Management

The first half of the year has been a positive one for investors, with strong returns across all major asset classes. Total returns for US and EMU equities were 17% and 15% respectively. Asian markets returned 12%. US investment grade (IG) bonds returned 9% and their high yield (HY) counterparts 10%, while European IG and HY bonds delivered mid-to-high single-digit percentage returns. In emerging markets, total returns for equities were 10% versus 9% for USD-denominated sovereign bonds. 

Looking back, in our view, this performance was driven by shifts in Federal Reserve policy and the US-China trade dispute, which played out in three distinct acts:

  • The first act, from January to the end of April, was defined by a recovery in stock markets that took global equities to a record high. The rally was prompted by a pivot in Federal Reserve policy in December 2018, suggesting that interest rate hikes were on hold for the immediate future. Hopes also grew that the US-China trade dispute was close to resolution.
  • During act two, in May, renewed trade tensions took center stage as tariffs rose and the dispute broadened into the technology sector. The equity fallout was relatively contained, with global equities declining around 6%. But US bond yields fell sharply, as speculation grew that the Fed might actually start cutting rates.
  • In the final act, which began in early June, equity markets rose to a record high as the Fed completed its policy pivot and pre-emptive Fed rate cuts became the likeliest outcome. The rally was also supported by hopes, subsequently vindicated, that the meeting between Presidents Trump and Xi at the G20 summit would at least contribute to a truce in the trade dispute.

Looking ahead, we believe equities remain attractive relative to bonds – with a global equity risk premium of 5.8% compared with a long-term average of 3.5%. But global equities have returned 15% this year and absolute valuations based on the global price-to-earnings ratio are close to their 20-year average. So overall, we do not expect strong returns for any major asset class in the second half. In our base case, we expect markets to edge higher, but developments in trade negotiations and the outcome of the July Fed meeting are pivotal. 

  • Barring unusually strong economic data in the run-up to its July meeting, the Fed is likely to act pre-emptively to protect economic growth and underline its commitment to avoiding recession.
  • The G20 summit has kicked the can on trade decisions down the road. The meeting between Presidents Donald Trump and Xi Jinping succeeded in averting a breakdown of talks but failed to produce a breakthrough to reduce tariffs. Any worsening of trade tensions, regardless of Fed actions, would likely cause risk assets to suffer in the second half. Trump and Xi both have significant discretion over tariff policy, and sudden shifts in negotiating positions are possible, if unpredictable.

In such an environment we believe that investors should stay invested and diversified to remain positioned for long-term market growth. Not keeping some exposure to equities would mean betting against the Fed. Since 2009 and the financial crisis, the Fed has generally succeeded at pivoting the right way. 

If the Fed succeeds again, recession risks decline, and the cycle looks like it could be extended for longer, markets would likely benefit. We have positioned ourselves for this possibility by adopting a tactical overweight in equities and a regionally selective approach. We are overweight in EM FX – risk assets and carry trades can be expected to perform well in the event of pre-emptive Fed rate cuts. Meanwhile, we position for the risk that the Fed disappoints the market by cutting rates less than it expects through an underweight in the 2-year US Treasury relative to cash. We also include a number of counter-cyclical positions to protect against the risk of a breakdown in trade talks and other downside risks.

More broadly, we believe there are a number of steps investors can take to make sure they’re well positioned for the current environment: 

Plan – Many investors make their costliest errors during times of uncertainty. During December’s and May’s risk asset sell-off, did you see opportunity and buy, or threat and sell? Selling out during a correction and not re-entering the market can potentially destroy your performance for the year. Having a clear plan can help reduce the danger of falling prey to costly actions. Our Liquidity. Longevity. Legacy. approach to wealth management aims to ensure investors have sufficient cash on hand to meet near-term obligations, while investing to meet longer-term goals. 

Protect – The risk that trade talks break down and that the Fed makes a policy error are two of the reasons why investors need to think carefully about how to protect against portfolio downside. One key part of this is diversification, across both regions and asset classes. Employing quantitative strategies to reduce equity positions in times of high volatility is another way to control portfolio risk, as is using structured strategies to take out protection against market downside. 

Grow – Investors also need to ensure that portfolios are invested to deliver the long-term compounded returns needed to achieve their financial goals. It looks likely that interest rates could move lower and stay at low levels for the foreseeable future. This means we emphasize limiting allocations to cash, while engaging in yield enhancement strategies to help improve the potential for compounded returns over time. Furthermore, we look at companies exposed to enduring long-term trends. 

Attractive equity risk premium – stocks remain attractively valued relative to bonds