Market consolidation provides opportunities

Trade tensions unsettle markets

After entering May at a high for the year, the equity market seemed to have followed the old adage “Sell in May and go away”.

However, this year the loss of 6.2% in global equity markets in May, had nothing to do with seasonality. Trade tensions escalated rapidly between the US and China, manufacturing data in the US, Germany and Japan disappointed, despite low expectations, and there were signs that the US Federal Reserve (Fed) might be less dovish than expected.

The aforementioned events also impacted other markets, with credit spreads widening, 10-year US Treasury yields going back down to 2.1% - the lowest level since 2017 - and oil prices falling 16%.

A tactical opportunity

As we highlighted in our first “Market Perspectives” back in April, it is typical to see higher volatility as the economic cycle moves to a later stage, which is where we are currently. We also warned of geopolitical tensions being a catalyst for a pick-up in realised volatility. In that sense, as expected, the market is less about momentum and more about tactical opportunities at the moment. For this reason, we highlighted tactical opportunities as a key investment theme for the year.

We think that the current consolidation provides one of those opportunities. Indeed, we continue to assume that a recession is unlikely and that there will be some form of resolution to trade tensions. In that scenario, which is our base case, the potential rewards are starting to look increasingly attractive.

While risks remain, we think that the mood has turned too negative on risky assets, especially equities. In that area, technology has probably suffered disproportionally, as have Asia ex-Japan equities. Selective fixed income emerging markets are also attractive. The current discount applied to those areas of financial markets seems unwarranted.

The net bullish reading in the American Association of Individual Investors is close to its multi-year lows, reached in December 2018. This extreme negative sentiment in retail investors is usually a sign that the turn is close as capitulations happened. While the timing of a turn is always difficult, over a three-to six-month horizon, we would expect financial markets to regain composure and make back the recent loss.

From an investment strategy perspective, we continue to have a positive bias towards late-cycle positioning. Quality and active management should do well in such market conditions.

Finally, the current trade tensions might impact inflation, increasing the risks of inflation moving higher from currently low expectations. However, additional volatility also provides opportunities for yield enhancement strategies, another investment theme we are monitoring closely.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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