In the closing weeks of the year, a somber mood has gripped markets. 
January’s optimism faded long ago, and now, as investors recalibrate the level of future growth and markets reprice what multiple to put on that growth, risk appetite is under attack from all sides.
Earlier in the cycle, we treated such bouts of caution as opportunities to add risk to portfolios. Today, however, the cycle is distinctly mature, with limited capacity to absorb shocks, and financial conditions are tightening inexorably. Most crucially, the hurdle for sustained positive economic surprises, sufficient to reignite the bull market in risky assets, is beyond any reasonable scenario we can paint today.
At present, the objective probability of a recession in the next 12 months remains low, and higher frequency economic data are reasonable. However, the pickup in capex anticipated for the second half of the year hasn’t fully materialised, growth is dipping back to trend more quickly than expected, and data outside the US are a mixed bag. In sum, economic momentum is moderating just as US monetary policy is quickly approaching—some would argue is already in—tight territory. Given the shift in the economic environment, the ongoing path of policy tightening and the slowing of earnings growth we expect in 2019, we have chosen to meaningfully de-risk our multi-asset portfolios—most visibly by reducing stock-bond to a small underweight for the first time in nine years.
The decision to de-risk is not a sharp U-turn, but continues down a path that began in the middle of the year. The moderation of economic growth back to trend may yet play out benignly. If employment remains robust, the Federal Reserve does not over-tighten and the trade dispute ends positively, then optimism should eventually return to markets. Even so, this case would likely take several months to play out, during which time risk asset markets could well struggle. Moreover, any sign that a benign “soft landing” was under threat would likely weigh on markets. Simply put, the risk/reward calculus has shifted slowly but decisively over the course of 2018.
As global growth rates come back to trend, we expect renewed scrutiny on monetary policy. The Fed has followed a seemingly preordained path of rate hikes for much of 2018, and we expect hikes to continue, quarterly, until mid-2019. Nevertheless, Fed speakers are beginning to lay the groundwork for a shift to data dependency in their rate setting. With other central banks also withdrawing stimulus and increasing rates, Fed data dependency may be cold comfort to investors should growth falter and the market narrative pivot toward a sense that US policy is tight. To be clear, tighter policy doesn’t imply looming recession. But in combination with softer growth it makes for a more fragile economic mix in which business, investor and consumer confidence may struggle to withstand negative news flow from issues like trade and geopolitics.
In terms of asset allocation, we reduced stock-bond from a small overweight to a small underweight, remain neutral on credit but with increasing caution on some sectors and are overweight duration and cash—though specifically US dollars. These changes are a continuation of the increasing caution we’ve voiced over the course of 2018, but we would acknowledge that the decision to move from optimism on equities to a more circumspect stance is a meaningful change.
Within equities, we still favor the US and are skeptical of eurozone stocks. The US has led throughout this cycle and in weak markets this autumn failed to outperform, but we believe the earnings resilience of the US is superior and will be supportive over 2019. By contrast, political woes are simmering once again in Europe, recent earnings seasons were lackluster at best, and valuations aren’t cheap enough to be compelling. In our view, the same is true in emerging markets, where slower growth and the higher cost of US dollar funding both weigh on the earnings outlook; thus we take emerging market equity to a small underweight.
In fixed income, there is a stark real yield gap between the US and other regions at all points on the curve, so our cash and duration overweights really distill down to overweights in US cash, and US Treasuries—where ex-ante Sharpe ratios are now well ahead of those for US stocks for the first time in a decade.
Finally, credit continues to offer reasonable carry, but the fundamentals for investment grade credit have deteriorated; US high yield is a relative bright spot, but illiquidity risk is an important consideration late in the cycle.
Over most of the last decade, fading dips in sentiment and adding risk on market weakness worked well. We are now more inclined to reduce risk on any bounce in growth expectations or sentiment, since the constellation of factors that might trigger another surge in global growth, while not impossible, are, for the time being at least, implausible.
John Bilton is head of global multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.