Cautiously optimistic

Up to the 1st of May, the environment was supportive for risk assets. The release of the Q1 GDP growth rate at 3.2% QoQ annualised beat expectations. This number was however tainted by rising inventories whose effect is largely expected to abate going forward. At the same time, the rest of the world is showing signs of “green shoots” of economic recovery. China continued on its path of credit expansion, whose knock-on effects are seemingly starting to appear in Europe, Japan, and some Emerging Markets via potential bottoms forming in recent manufacturing PMI releases.

Monthly Fund Commentary
20 May 2019

Up to the 1st of May, the environment was supportive for risk assets. The release of the Q1 GDP growth rate at 3.2% QoQ annualised beat expectations. This number was however tainted by rising inventories whose effect is largely expected to abate going forward. At the same time, the rest of the world is showing signs of “green shoots” of economic recovery. China continued on its path of credit expansion, whose knock-on effects are seemingly starting to appear in Europe, Japan, and some Emerging Markets via potential bottoms forming in recent manufacturing PMI releases.

Simultaneously, the market began to price in a rate cut by the end of this year. The recent publication of U.S. inflation data disappointed and further fueled the debate and subsequent risk around monetary policy.

In Europe, worries over Mario Draghi’s successor intensified. In the Investment Adviser’s opinion these developments and fears highlight the extent to which the overall market’s outlook is now tied to a continued pace of central bank accommodation. According to the team this risk however seems distant, with the ECB about to launch its targeted longer-term refinancing operations (TLTRO) program, fueling further expectations of negative rates, while other central banks have re-emphasised monetary caution (i.e. Fed, the Bank of Japan, PBoC).

In turn, this partly explains why long term rates remain so low, whilst equities are close to all-time highs. The downward pressure on the 10-year UST came from a sharp drop in the term premium, highlighting the knock-on effects of a sluggish growth outlook for other Developed Markets.

Another aspect worth highlighting is money flows. Clearly, investors who favoured treasuries at the end of 2018 still have a pessimistic outlook and maintain their cautious stance as evidenced by the continued relative subscription strength seen in mutual bond funds versus equity mutual funds.

Portfolio Strategy

The Fund returned 2.27% (USD Institutional Class) over the month of April. In terms of positive equity contributors by sector, Information Technology took the lead, followed by Communication Services, and Financials. In terms of positive performance contributors at the stock-level, Walt Disney contributed the most, followed by Constellation Brands, and Facebook. On the other hand, Takeda Pharmaceuticals was the largest detractor, followed by Nitori Holdings and UnitedHealth Group.

Market Outlook

As highlighted above, major central banks have in the past been able to address various issues with additional accommodation. This said, a pause is not the same as a policy reversal, which the market is currently expecting.
To put this in context: 2018 saw 4 Fed rate hikes given the falling unemployment rate, whilst its gap to the neutral rate grew and associated policies remained easy.

Then, by the end of the year, markets declined rapidly as further planned hikes were perceived as a policy error. Consequently, financial conditions tightened and the Fed adjusted its stance by upgrading the risks related to external factors and below-target inflation. Ever since, the equity market has regained and surpassed the level that initially triggered the Central Bank’s stance, the unemployment rate has continued along the same path, and the external environment (e.g. China) has improved. This leaves us with inflation, which has recently shown transitory weakness.

Despite these developments, the narrative for cutting rates in the U.S. has continuously gained traction. The market is applying pressure via its stance to the Fed’s fund futures, with President Trump and vice-President Pence also having expressed a desire to see rates move down, and some policy makers (i.e. Chicago’s Fed president Evans) raising the prospect of cuts.

This said, the Investment Adviser still believes that the base case does not warrant a rate cut and that such a move would be very hard to manage. Growth fears outside of the base case could be a reason (particularly if intensified by tighter financial conditions), which the Fed would need to see materialise. Tighter financial conditions, a key part of what facilitated the policy shift in December, could inspire policy easing but would need to be combined with growth or concerns regarding inflation gaining traction.

Nonetheless, monetary policies have eased globally and there are many ways a cut could be justified (depending on how things unfold). In the Investment Adviser’s opinion, a cut is thus more plausible today than fundamentals indicate. This said, given the Fed’s current view that inflation weakness is transitory, any cut would require one of the above arguments to mature and consolidate. Consequently, an additional shift from the Fed might be perceived differently this time around and could have various negative effects.

In light of these developments, the Investment Adviser has continued to adopt a gradual yet more defensive stance in order to capture any short term opportunity an unsubstantiated drawdown may offer, whilst at the same time still adopting a more risk-adjusted stance over the medium term.

The views and statements contained herein are those of the Eric Sturdza Group in their capacity as Investment Advisers to the Funds as of 13/05/2019 and are based on internal research and modelling.