What key theme is likely to shape markets in 2019?
I am probably not alone in thinking that a background of increased volatility will be an important feature of both equity and fixed income markets in 2019 and that searching for investments that help diversify away from these traditional asset classes will be high on investors’ agendas. However, as we have witnessed during 2018, providing portfolio diversification has been challenging for many alternative managers. The key to success in 2019, in our view, will be in providing an attractive return while having little or no beta to traditional assets.
We have had artificially low volatility underpinned by the easiest monetary conditions since the phrase “geopolitics” was originally coined by Swedish political scientist Rudolf Kjellén at the turn of the twentieth century. While this has certainly helped resurrect economic growth from the ashes of the Great Financial Crisis(GFC), we are now starting to see this stimulus withdrawn from the economy.
I would argue that many of the lessons that should have been learned from the GFC have been ignored, or ‘kicked down the road’, due to this period of cheap money. The leverage effect has fuelled the price of risk assets, benefiting equities, and put a cap on interest rates, benefiting bonds. I see 2019 as a period where this ‘Goldilocks’ scenario could change.
What does this mean for investors?
This is not revolutionary thinking. Investors have known about the effect of this stimulus, they just have not needed to do anything about it. In fact, delaying any asset allocation away from risk assets has hitherto been profitable and the best decision. At some point, however, that will change. I believe the question investors should be asking is: “where do I seek diversification?”
If the lessons of the two sharp drawdowns we have witnessed during 2018 are anything to go by, this diversification is hard to come by. During these periods of increased market stress, we have seen returns from many alternative asset managers correlate highly with the drawdowns in equities, and – on both occasions in 2018 – this has occurred after a sharp rise in interest rates. As such, alternatives as an asset class have not generally delivered on their aim of offering diversification.
What are the opportunities for alternatives in 2019?
The opportunities for 2019 lie in providing strategies that genuinely help our clients manage their investments through this uncertain time. Within the Diversified Alternatives Team at Janus Henderson, we continuously focus on delivering attractive risk-adjusted returns with little or no equity or fixed income beta. We search for what is known as ‘convexity’ in our portfolios: strategies that have a positive correlation to volatility. So far in 2018, this has worked and we look forward to providing clients with investments that have little or no beta to traditional assets in 2019.
Global commodities outlook: all eyes on the US
The major themes for commodity markets will be the carryover effects of the volatility seen in 2018. Dominating global financial markets over 2018 were the trade tensions between China and the US, broader geopolitical uncertainty, the forward path for the US Federal Reserve (Fed), inflation and the US dollar. Each of these factors will continue to shape markets in 2019, while the ever-present bottom-up factors of actual and potential commodity demand and weather will also play a role.
From a cyclical-perspective, and unlike the equity and bond markets, commodities are going into their fourth year of recovery from their low point in January 2016. While this presents a case for the inclusion of commodities as a genuine diversifier within an investment portfolio, the risks to commodities resulting from escalating trade and geopolitical tensions must (as always) be actively managed.
Where do you see the most important opportunities and risks within your asset class?
There are a number of risks and opportunities to commodities, with the primary risk being the current tensions between China and the US on trade and tariffs. A stalemate or resolution on this one issue provides both a risk and opportunity to most commodity markets. As such, the path this takes is possibly the single biggest marginal factor in pricing.
The second factor is the relative speed of the normalisation path that the Fed takes in 2019. Any change to interest rate policy, wording or Fed dot plots would have a potentially material impact on the US dollar, relative interest rates and real interest rates, broadly affecting commodities and more specifically impacting markets such as gold.
Should global markets continue to exhibit signs of stress, and US corporate earnings show signs of slowing, a slowdown in the speed of normalisation would be materially positive for commodities.
Energy and grain markets provide the greatest degree of variability and, as such, greatest opportunity and risk. The recent slide in benchmark crude oil prices and sharp rise in Natural Gas prices highlight how multiple factors like weather, geopolitics and US trade policy can affect the outlook of markets, even in the same sectors.
A further deterioration in energy prices from current levels (low US$50 per barrel) would start to impact production and provide the impetus for OPEC and Russia to reduce production in order to stabilise markets.
Grain markets provide the greatest potential reward to risk opportunities from current price levels. A combination of factors such as US dollar weakness, demand surprising on the upside, adverse weather and a resolution to trade tensions would all provide material upside catalysts.
Emerging market dynamics will (as always) affect specific markets. A bottoming in currencies such as the Brazilian real, for example, would provide a base and potential upside for commodities sensitive to Brazilian dynamics, such as Coffee and Sugar.
How have your experiences in 2018 shifted your approach or outlook for 2019?
Commodity markets in 2018 have highlighted the ongoing risks from left and right tail events, which has become evident in recent weeks in energy markets, in particular Crude Oil (negative) and Natural Gas (positive). The recent spike in Natural Gas prices over a very short time horizon has reinforced both the opportunities to generate truly diversified commodity markets, but also the underlying risks of being overly exposed through incorrect positioning. Term structure management and appropriate leverage in 2019 will be a critical factor in effectively managing risks and providing relative and absolute positive returns in the sector.
Which chart do you think will be a key indicator for 2019?
The US dollar is the most important chart driving all commodity markets. Any signs of a meaningful slowdown in US growth, interest rates or corporate earnings will impact the US dollar and would be positive for commodities as an asset class. To illustrate the effect of the US dollar, Chart 1 highlights the intertwined relationship of the US dollar and commodities. The US dollar historically has had a major impact on the path for commodity markets and will continue to do so in 2019.
Published by Janus HendersonAuthors: David Elms, Head of Diversified Alternatives and Mathew Kaleel, Portfolio Manager, Diversified Alternatives.