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Geopolitics, Positioning, & Sentiment Pose Near-Term Risks

January 2020

Leading into 2019, investors had either relatively muted or downright dire expectations for stocks on the heels of a 13.5 percent sell-off in the 4th quarter of 2018, a pullback that saw the S&P 500 dip nearly 20 percent from its peak. The December 2018 decline in stocks was driven by the perception that U.S. monetary policy was too tight amid rising economic and trade-related uncertainty, increasing the odds of an economic downturn in 2019. Amidst the growing backlash in the financial markets, in early-2019 Chairman Powell and other FOMC members began to talk back what only a month before had been a relatively hawkish message. This proved effective in alleviating what had been growing fears of recession. The FOMC ultimately cut the fed funds rate three times during 2019 by a total of 75 basis points. Global monetary easing and the sea of liquidity brought forth with it, combined with ever-present hope surrounding a U.S./China trade accord, led investors and traders to buy global stocks amid paltry sovereign bond yields. Along with liquidity, a lack of viable alternatives in which to deploy capital led to a 31.5 percent return from the S&P 500, a 25.5 percent return from the small-cap Russell 2000 index, and a 23.1 percent return in the MSCI World ex US index, each on a total return basis. Entering 2020 on the heels of 2019’s ‘everything rally,’ we expect a slower-growth environment, increasing the importance of discipline, selectivity, and an abundance of caution in the new year.

Geopolitical risk is a constant, with the early-January U.S. strike that killed a senior Iranian military leader in Iraq being the most recent reminder. Geopolitical hotspots continue to flare up around the globe and can present a significant challenge when attempting to quantify the magnitude and duration of any potential market response. Outside of geopolitics, which is typically more impactful on tactical or extremely short-term trading strategies, the greatest risks for equity investors early in the new year appear to be tied to positioning and increased leverage on the part of institutional players, along with overly optimistic investor sentiment and complacency. In a 180-degree about-face from the start of 2019, both retail and institutional investors have embraced the rally in global equities to varying degrees. While retail investors remain nervous, the fear of missing out on further gains led them to raise stock allocations as prices moved higher during the 4th quarter. This group maintains sizable holdings of cash and short-term bonds, but it’s going to be increasingly difficult for stocks to pry it away.

Hedge funds as a group increased exposure to stocks throughout the 4th quarter, borrowing cheap capital to buy equities in advance of what they hoped would be a Santa Claus rally. With equity exposure and leverage up, should investors continue to reduce exposure to hedge funds, selling to meet redemptions and potential de-risking amid U.S./Iran tensions could lead to weakness in stocks. As a group, hedge funds trailed the S&P 500 by 20-plus percent in ‘19, which should come as little surprise as broader market indices rose sharply. While the S&P 500 is far from an appropriate benchmark for hedge fund-like strategies, investors continue to focus on the opportunity cost of allocating capital to hedge funds over stocks after a decade of poor relative performance – a focus that has led some large, high-profile pensions and endowments to pull capital from the space. Hedge funds may have a place in a diversified portfolio, but a manager must be carefully selected through thorough due diligence, and education is paramount to ensure expectations are properly set. An in-depth discussion surrounding what hedge funds do, and don’t do, must be had before an allocation is made.

In 2019, with trade-related, impeachment, and economic slowdown fears as reasons to sell, investors and traders pressed long positions, buying in large part due to few appealing alternative areas in which to park capital amid falling bond yields. Domestic markets were pulled higher by technology, with the tech-heavy Nasdaq Composite Index rising 36.7 percent. Leadership broadened out during the fourth quarter with economically sensitive and value-oriented sectors such as financial services, industrials, and health care, a battleground sector entering what is likely to be a ‘promises made’ presidential election year on drug pricing, joining in the rally. Volatility was contained throughout 2019, reminiscent of the equity backdrop in 2017, with the CBOE Volatility Index (VIX) failing to eclipse the 25 level during the year. It’s not lost on us that 2016, 2018, and 2019 all brought spikes in volatility in January, and the volatility setup now appears eerily similar to us. While falling short of calling for a deep correction, a pullback can’t be ruled out given how far we’ve rallied since the start of the 4th quarter and how investor enthusiasm has returned. We maintain a constructive view on domestic large-cap and emerging market stocks, while continuing to take a cautious stance on international-developed markets, despite the recent rebound. While we foresee another up year for global equities in 2020, our expectations are tempered relative to where we were entering 2019, and investor expectations likely need to be as well.

Source: Bloomberg, Factset

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