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Only 20% of asset classes generate positive returns

One explanation could be that investors now overreact to even modest changes late in cycles after not foreseeing the financial crisis, say JPMorgan Chase & Co strategists

New York

ONLY during the 1970s stagflation period and the global financial crisis have so many asset classes had negative returns in a year. The latter may have a lot to do with why it is happening again.

Investors now overreact to even modest changes late in cycles after not foreseeing the financial crisis, wrote JPMorgan Chase & Co strategists led by John Normand in a note last Friday. Other plausible explanations could be that the global economy and earnings have reached a turning point, or that the Federal Reserve is committing a policy error, they added.

"The percentage of asset classes that has generated positive returns this year is only 20 per cent, a share that has never been so low outside of 1970s stagflation episodes and the global financial crisis," the strategists wrote. "Every market but the Nasdaq, commodities and US leveraged loans has underperformed USD cash in 2018."

The strategists have "no argument with the obvious statement" that markets are tumbling because global growth and US earnings are peaking. However, they said, slower growth on those fronts - at least if it remains around long-term average levels - usually has not been a sufficient condition for investors to turn defensive.

"We had expected outperformance for another two to three quarters given near-neutral Fed policy, record share buybacks and significant deleveraging" by some equity investors before earnings season began, the strategists wrote. "This month, markets clearly don't share our time-limited optimism, perhaps given growing fear that the Fed is committing a policy mistake by tightening to restrictive levels eventually."

The strategists recommend a semi-cyclical portfolio in coming months:

  • Overweight developed-market equities versus bonds and credit
  • Net neutral emerging-market risk via overweight equities and short duration, underweight sovereigns and neutral corporates and FX
  • Several country-specific overweights in Latin America
  • Global currency trades become tactical, but long the US dollar

"Does the endgame need to be priced now? If not, 2018 looks like the year of overreaction," the strategists wrote.

A Fed rate closer to restrictive levels and a much slower pace of earnings growth is probably needed to justify defensive positioning, the report said. The strategists said that historically, equities sometimes turn only when the economy enters a recession (like in 2007), though also in some cases a year before the slump (around 2001). So given potential for a recession around 2020, they see potential for rotating into defensive positioning around mid-2019.

The risk has always been that markets would turn earlier, as "investors' mindset has changed this cycle", Mr Normand and colleagues said.

The length of the expansion and slow Fed tightening cycle have given investors time to build exposures and to study "the anatomy of turning points and to contemplate the exit constraints from lower market liquidity", according to the note.

This could be why defensive trades in equities and fixed income are working recently, the authors said, though the current chances of recession - 30 per cent according to a JPMorgan model - are far below levels usually associated with lasting outperformance of those strategies.

"If complacency is one of the words most associated with the pre-Lehman years," then "paranoia may be the one most tied to what remains of this cycle", they wrote.

"We are not yet willing to run the year of tracking error implied by holding broadly defensive exposure until the global economy weakens materially, so continue to favour the semi-cyclical strategy instead." BLOOMBERG

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