The first half of 2018 has been weak for virtually all asset classes except the particularly volatile commodity sector. In equities the S&P 500 was almost flat (+1.7%) and most other equity markets were flattish or down -3% to -5%.
In fixed income the iBoxx Corporate Investment Grade index was down 4.3%. We view this as a significant development which illustrates well the often underestimated risk related to fixed income. While it is often presented as the “safe part” of a portfolio, it is in reality subject, like any investment, to significant risks, particularly the risk of rising interest rates. This risk has been latent for the past couple of years – when interest rates get close to zero they cannot fall much lower but on the other side they have room to go up markedly.
It is noteworthy that Jamie Dimon, CEO of JP Morgan, one of the wisest financial people of our time, has recently mentioned the possibility that the interest rate on the 10-year Treasuries could reach 5% after it temporarily went above the 3% level in April. This would have major implications for the financial markets and could lead to significant losses on long-dated fixed incomed bonds, which we have been avoiding for a long time. A few months ago, such a scenario would have been considered as science-fiction by many. This illustrates well the need to be ahead of the market in anticipating the risks.
Beside the particularly important interest rate risk there remains a range of geopolitical risks. The increasing tensions between the US and the world in trade matters is starting to have implications for companies but the real extent and impact is still unclear and might be less dramatic than the spectacular newspaper headlines regarding “trade wars” would suggest. The election of right-wing parties hostile to the European Union in Italy represents a further risk but the ability of the newly elected to effectively implement dramatic changes in the short term is limited.
A significant development in recent weeks has been the dramatic loss in value of the Turkish lira which has the potential of creating a full-blown economic crisis in Turkey. As European banks have exposure to Turkish banks they could be affected by such a situation although the magnitude of the exposure is relatively limited (and not comparable for example with the major exposure to Italian debt). In addition, Turkey is the fifth-largest trading partner of the European Union and exports could also be affected. In view of this risk we recommend minimizing exposure to the Euro and European equity markets.
American equities did well in July-August; the S&P is now up 6.2% since the beginning of the year. The performance of equity markets in other countries and of most other asset classes continues to be weak.
No one knows what will happen in the next six months but we believe that in current circumstances one should rather stay on the side of caution.