'PAYBACK': JP Morgan explains why 2018 hasn't gone to script for financial markets

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  • 2018 has been very different when it comes to major asset market returns, except US stocks.
  • Gains have been small in number and scale, in contrast to 2017 when almost everything, aside from the USD, enjoyed positive returns.
  • JP Morgan expects the global economy to recover from recent wobbles, potentially supporting emerging markets, but attaches several caveats.

2018 has been a very different year when it comes to major asset market returns, with the exception of US stocks.

Gains have not only been small in number but also small in scale, a performance in stark contrast to 2017 when almost everything, aside from the US dollar, enjoyed positive positive returns.

As seen in the chart below from JP Morgan, outside of US stocks, the US dollar and a handful of other major asset classes including commodities, returns have been few and far between, particularly in emerging markets.

The latter, with the odd exception, has been crunched.

JP Morgan

So what happened since the end of 2017 to explain the current funk? 2018 was, after all, supposed to be the year that the synchronised global economic recovery went up another gear, something that saw investors at the start of the year rush to buy pretty much any asset that was linked to the global growth story.

While there are many explanations out there, including geopolitical concerns, softer economic data outside of the United States and divergent monetary policy outlooks between the US Fed and other major central banks, JP Morgan has a simpler explanation.

“With 2018 half complete, the year is delivering broad payback following 2017’s extraordinarily-high returns and unusually-low volatility,” the bank says.

“Over half of major asset classes have underperformed cash.”

JP Morgan says what’s been seen this year has been a recalibration among investors as to what exactly is normal market returns.

“The simplest explanation for this pattern is that mean reversion in markets is an inevitable phenomenon, and since 2017’s risk-adjusted returns were two or three times their long-term average in most asset classes but commodities, a 2018 that delivered trivial gains or even losses would still leave the average of the past two years respectable,” it says.

“A more complete view of what’s driving such mediocrity is the late-cycle perspective: the second-oldest US expansion in post-war history has created numerous imbalances in fundamentals and valuations, which have rendered markets quite sensitive to this year’s succession of mini economic and geopolitical shocks.”

Indeed, after being among the standout performers in 2017, European and emerging markets have been hit particularly hard, reflecting that asset prices were near priced to perfection before the latest trade and economic wobbles hit.

Only US stocks have really carried the momentum seen last year into 2018, and even then JP Morgan says that only reflects that tech and consumer discretionary have rallied, masking weakness in cyclicals like financials, industrials and materials.

The question many are now asking is whether the wobbles seen in the first half of the year will continue, or become amplified, as we approach 2019?

JP Morgan thinks the global economy will improve once again, potentially supporting dip-buying in beaten up emerging markets.

However, it attaches several caveats to that view.

“Most of the risks we thought would materialise progressively over 2018 were instead front-loaded, and thus there’s less scope for surprise in the second half,” it says.

“If we are right that synchronised growth will return because financial conditions are loose and corporate profits plus labor markets healthy everywhere… then the most interesting alpha opportunity in the second half will come from switching from our current neutral position to overweight in emerging market equities, bonds and FX.

“That call would also involve a move more broadly into USD shorts.”

JP Morgan says both trades would likely require stronger non-US growth, clearer non-US politics and a less-aggressive US trade policy.

Given the level of uncertainty that currently exists on all three fronts, it says caution, and patience, is warranted.

“These conditions may materialise progressively [over the Northern hemisphere supper] but are not worth pre-positioning for now,” it says.

“The short-term view remains positive on the dollar and negative on emerging market assets, though forecasts into year-end are more constructive.”

However, over the longer term, JP Morgan says any potential shift into emerging markets to the detriment of the US dollar would only be tactical, rather than positioning for a longer-lasting trend.

“The broader message will be the one we’ve carried all year — that the US economy and global market are in the twilight of the mid-cycle and thus markets should deliver below-average risk-adjusted returns,” it says.

“Cross-asset strategy for the second half remains long growth assets through equities, but continues the slow and gradual process of averaging out of cyclical allocations on the expectation that macro, policy and liquidity challenges will likely increase over the next 12-18 months.”

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