Use the recent rally to prepare your portfolio for the next economic cycle

Expect the upswing to continue in the near term, says Steven Rees of JP Morgan Private Bank

A trader works on the floor of the New York Stock Exchange. Global developed equity markets are up about 14 per cent from their late December trough. Photo: Associated Press

After a difficult fourth quarter of 2018, markets are off to a much better start so far in 2019.

Global developed equity markets are up about 14 per cent from their late December trough. That said, equity markets are still down 7 per cent since the end of September. Concerns of slowing global growth, including a potential US recession, and unresolved trade disputes between the US and China have faded and investors have applauded recent supportive commentary from the US Federal Reserve.

Don't be surprised if the market continues to rally a bit in the near-term given the Fed’s dovish decision to pause their rate hike path. However, recent revisions to consensus earnings estimates have brought earning per share (EPS) growth expectations down from 10 per cent to minus 5 per cent in 2019, limiting significant market upside, while US equity market valuation is now around 16 times forward earnings more or less, in line with historic averages. However, as earnings growth expectations continue to come down, it is difficult to see valuations returning to the 18 times levels we saw early 2018.  While the risk/reward looks better in the US relative to other markets, such as Europe, for example, we continue recommending investors adopt a late cycle framework to position portfolios for increased volatility and potential downside in 2020/2021.

We recommend using market strength to rotate core equity allocations to more defensive areas including equity income and healthcare.  One exception to this more defensive stance is our positive view on technology, which we think looks particularly attractive in the near-term, post the fourth quarter of 2018 selloff.

While this marks a departure from our more defensive stance, we still see tremendous growth potential in themes such as Artificial Intelligence, cloud, mobility, and electric vehicles. Technological change is creating disruption across many sectors, and that is creating an opportunity for active management to pick the winners and avoid the losers.

In addition, first quarter earnings across the tech sector generally came in better than feared with some signs that the important semiconductor cycle could be nearing a bottom.

We remain underweight in European equities and prefer Emerging Markets at current levels.  Eurozone macro data has continued to disappoint as European growth has continued to slow.  Trend growth in Europe is around 1 per cent, below the US at around 2 per cent and globally at around 3.5 per cent.  On a longer-term basis, EM equities from a growth and valuation perspective look attractive, though trade resolution will be the key driver of performance in the near-term.

We also expect a positive market bump from more China fiscal stimulus, and any agreement that postpones or cancels the imposition of 25 per cent tariffs on $200-$460 billion of Chinese imports.  After that, the EM equity rally could take a breather, given uncertainties around possible tariffs on European and Japanese auto/parts exports, and slowing corporate profit momentum.

EM equities have started to recover, holding up better during the December selloff relative to developed market equities. Year-to-date, MSCI EM equities are up 8 per cent, but it is important to keep in mind that the index has still lagged the US equity market by close to 50 percentage points over the last five years.

Within fixed income, in our managed portfolios, we recently reduced credit positions, continuing our gradual rotation into high quality core bonds.  Since late December, we‘ve seen both high yield and emerging market debt return about 5 per cent.  Investment grade credit is up around 3 per cent since then as well.

The effect of slower growth can be seen across government bond yields, especially in Europe.  A year ago, 10-year German government bonds (Bunds) had a yield around 75 basis points.  At the end of December, those yields were 24bps.  This week, the yield on a 10-year Bund fell to 10bps.

The collapse in rates reflects slower growth and an expectation that the European Central Bank is likely to be easing monetary policy again before hiking.  For US dollar investors, we advise maintaining a higher than normal level of cash on deposit, which can provide an important source of yield and can also be put to work should market volatility return.

Steven Rees is the managing director and global investments strategist at JP Morgan Private Bank