2018 was a horrific year for major equity indices. It was also a very challenging year for asset allocators. The old principles of portfolio diversification did not work to the same success as previous years, with almost all sub asset classes posting negative returns, except cash in USD. 

Both the economic environment and investor sentiment changed swiftly during the year. Fears of an overheating US economy shifted toward the possibility of an imminent recession only a few weeks ago. Sentiment moved from euphoria, where investors did not pay attention to the risks (trade wars, Italian political situation etc), to extreme bearishness.

To better assess the 2019 outlook, we need to take into consideration one important development: main central banks are not expected to grow their balance sheets anymore after 10 years of liquidity injections. The end of the ECB quantitative programme has been well-communicated by officials, and the Fed remains in tightening mode. We would like to highlight two consequences of this new situation. First, Central Banks, through their easy monetary policies, have acted lenders of last resort, helping financial markets to stabilize when needed, and also offering a protective put on risky assets. In this regard, the drastic recent change of tone of US Fed Chairman Powell is striking: he has been forced to adapt his speech after the market turmoil, by mentioning that he “is listening sensitively to the message that markets are sending”. Secondly, removal of liquidities tends to exacerbate market moves, hence feeding cross asset volatility.

In such a context, being overly exposed to equities seems unwarranted as managing risk is becoming increasingly important. Moreover, the current economic situation is clearly pointing to a global slowdown. Europe has been decelerating since Q1 2018 while China is adopting stimulative policies to restore growth. Even the US economy, which was shielded from global economic weaknesses, seems to be recoupling with the rest of the world. December ISM manufacturing’s decline was one of the biggest by historical standards, clearly suggesting that the US economic momentum is losing steam. 

Given the strength of the US labor market (with 312k jobs created in December), we have good reason to believe that the US economy will not face a sour scenario this year, i.e. a sudden recession. Nevertheless, we acknowledge that companies’ earnings might be at risk of disappointment, and relying solely on attractive valuations is not enough to justify an overweight stance on equities, particularly at a time when the technical picture has turned negative. 

In the short-term, given the widespread panic levels reached on different sentiment indicators, a contrarian rebound in risky assets might take place. And if the current bounce, initiated in late December, is extending, it will be a good opportunity to further reduce equity exposure, hence increasing the cash level, one of the best stabilizing assets in a portfolio.

Finally, we believe that traditional safe haven assets (gold, treasuries and JPY in particular), which posted disappointing performances in 2018, will be able to generate positive returns this year in a context of rising volatility. It might be a good time (after a seven-year bear market) to increase positions in the yellow metal as US real interest rates will likely fade going forward. Moreover, any weakening in the dollar will feed gold appreciation.