Investment traffic lights

"What was that?" those with tender souls might say, as they look back on the month of February. "That's it?" sturdier market participants might reply. After all, it turned out to be a surprisingly mild market correction, in the end. Of course, both perspectives have some merit. After a strong start into the year, markets surprisingly slumped at the beginning of the month. The S&P 500 lost 10% in nine days, technically went into correction territory and ended a record-breaking run without declines of five percent or more. February also marked the end of 15 record breaking months that saw not a single negative total return at the end of the month (the same is true of the MSCI AC World). That sounds dramatic. However, that decline only set back the S&P 500 by 3 months. Moreover, it pretty much corresponds to the average drawdown you have tended to see at least once each year over the past 40 years, as we showed in our Chart of the Week of February 9th . On top of that, equity markets recovered quite quickly. Most are already at higher levels than at the beginning of 2018. One reason for this is that technical factors played key roles in this correction. Amongst other issues, this included forced selling by some market participants bound by risk parameters (see CIO Flash - Back to normality ). Volatility rose far more quickly on a single day in certain equity markets than ever before. The VIX is still well above its average level of recent months. And yet, we would describe higher volatility as a sign of a return of slightly more normal times. This new normalcy is also what caused investors to fret throughout the month of February, in terms of what it might mean for interest rates and the dollar. To be sure, yields on 10-year U.S. Treasuries only rose by 15 basis points, after an increase of 30 basis points in January. But that was enough to cause the yield differential between German and U.S. sovereign bonds to widen to multi-year peaks. Despite this, the dollar merely stabilized at a fairly weak level.

After the market correction, we confirmed most of our year-end forecasts in an extraordinary CIO review. This was mainly due to the continuing strong macro-economic prospects world-wide. While technical factors probably reinforced the correction, another source has probably been growing inflation concerns. After all, we saw several surprisingly strong readings on the robustness of U.S. economic momentum at the end of January. Despite this, we would consider inflation fears to be overdone, at this stage and do not expect an overshooting any time soon (see also our report "Low and slow" does not equal "Never, ever" ). By the end of 2019, we expect the U.S. Federal Reserve to have hiked interest rates six times. We see three rate hikes in the current year. The rise in U.S. Treasury yields has not solely been driven by high inflation expectations. Instead, the key driver was higher real interest rates, as we showed in our Chart of the Week of February 16th . This shouldn't be seen as a negative for equity markets in our view, because it suggests that bond investors are seeing improvements in the underlying economic outlook. So, what would make us more cautious? An increase of (nominal) yields on 10-year U.S. Treasuries above 3.5% or an inverted U.S. yield curve. The purchasing managers indices suggest a similar conclusion: they remain very strong, but have lately been losing some steam. Earnings estimates reinforce this picture: after upwards revisions in January, they stabilized in February. That is still an unusually strong earnings picture around this time of the calendar year and should prove supportive for equity markets. However, it is also likely to limit the upside. From a sector and regional perspective, we decided to retain our tactical allocations. Our decision to maintain our exposure to technology shares paid off, given their strong recovery.

For fixed income and currencies, by contrast, we have made some tactical and strategic changes in February. We continue to think that we have already seen the bulk of the rise in U.S. yields, just as we did at the beginning of last month. Nevertheless, we have raised our year end forecast from 2.6% to 3% for 10-year and from 2.1% to 2.5% for 2-year U.S. Treasuries. For 10-year German Bunds, we raised our yield forecast from 0.8% to 1%. We also cut our spread expectations for sovereign bonds from the Eurozoneperiphery which allowed us to raise Italian sovereigns (10-year) to overweight. Our base case remains that political developments in Europe will not spoil the market mood. However, we are well aware of the risks surrounding Italy's parliamentary elections, which we have described in detail in our asset-class perspective An Italian muddle . Other risks include the coalition formation in Germany and ongoing Brexit talks. All in all, we are tactically positioned neutral for sovereign bonds (coming from underweight for Bunds), with a slight negative bias. We have also cut our assessment on U.S. municipals back to neutral.

For corporate bonds, we remain positive on investment grade in Europe and raised our assessment to positive for U.S. investment grade. The same is true in high yield, where we are now positive on both Europe and the United States. The recent correction brought more interesting valuations, while we believe fundamentals remain solid. In emerging markets, we cut corporate bonds back to neutral and remain positive on sovereigns. While we have been neutral on all major currency pairs last month, we now expect the dollar to strengthen against the euro and the Japanese yen.

• The focus of our tactical view for fixed income is on trends in bond prices, not yields.

• The focus of our strategic view for sovereign bonds is on yields, not trends in bond prices.

• For corporates and securitized/specialties bonds, the arrows depict the respective option-adjusted spread.

• For bonds not denominated in euros, the illustration depicts the spread in comparison with U.S. Treasuries. For bonds denominated in euros, the illustration depicts the spread in comparison with German Bunds.

• For emerging-market sovereign bonds, the illustration depicts the spread in comparison with U.S. Treasuries.

• Both spread and yield trends influence the bond value. Investors who aim to profit only from spread trends should hedge against changing interest rates.

• Positive view

• Neutral view

• Negative view

• A circled traffic light indicates that there is a commentary on the topic.

• The traffic lights’ history is shown in the small graphs.

Equity indices, exchange rates and alternative investments:

The arrows signal whether we expect to see an upward trend , a sideways trend or a downward trend .

The arrows’ colors illustrate the return opportunities for long-only investors.

• Positive return potential for long-only investors

• Limited return opportunity as well as downside risk

• Negative return potential for long-only investors

Fixed Income:

For sovereign bonds, denotes rising yields, unchanged yields and falling yields.For corporates, securitized/specialties and emerging-market bonds, the arrows depict the option-adjusted spread over U.S. Treasuries: depicts a rising spread, a sideways trend and a falling spread.

The arrows’ colors illustrate the return opportunities for long-only investors.

• Positive return potential for long-only investors

• Limited return opportunity as well as downside risk

• Negative return potential for long-only investors

Footnotes:

* as of 2/28/18

¹ Spread over German Bunds in basis points

² These traffic-light indicators are only meaningful for existing private-equity portfolios