Emiel: So in our last blog we highlighted a few deals which could provide markets with fresh impetus next year. What about central banks? Where do we see potential for a dovish tilt in 2019?

 

Tim (Head of Economics): In the US, we can see a path where quarterly rate hikes continue until the end of 2019. However, Jerome Powell has made it clear that the US Federal Reserve (Fed) is becoming more data-dependent. A pause in the tightening cycle becomes more likely if inflation remains contained or growth disappoints.

 

Emiel: So a more dovish Fed would obviously be favourable to markets. How about at the European Central Bank (ECB)?

 

Hetal (European Economist): Mario Draghi (ECB President) is leaving after deftly navigating a sovereign debt crisis, steering the ECB through the Grexit saga and chartering new territory in the form of negative rates and European quantitative easing. While investors would love a more dovish replacement, it is hard to overestimate how much investors fear a markedly hawkish successor.

 

Erik (Emerging Market Economist): A dovish Chinese central bank could be key for success in emerging markets next year. We expect China to step up its stimulus heading into next year, which could be positive for commodities and associated assets such as debt issued by commodity producers and emerging market local currency debt.

 

Lars (Equity Strategist): True. Last year we were negative on emerging market equity due to China’s high weight in the index. Our expectation of stimulus means we’re more neutral going into 2019.

  

Emiel: Thanks all. However, if these more positive scenarios don’t pan out, as I’ve mentioned before, I like investing in 'smart hedges': those that don’t lose much in the positive scenario or our base case, but could perform strongly if the reality is more negative than anticipated. What smart hedges are we looking at?

 

Chris (Fixed Income Strategist): One of these may be inflation-linked bonds. In principle, the shock-absorbing capacity of bonds could disappear if inflation were to break out. Instead of reducing portfolio risk, bonds could move with equities and exacerbate the problem. Holding inflation-linked bonds (we particularly like US inflation-linked bonds) could help to mitigate some of this risk.

 

Emiel: True. Other possible hedges I like are the US dollar and the yen. If global financial conditions tighten, this is likely to be negative for many asset classes. But demand for these currencies should increase, which could help to insulate portfolios.

 

 

For a UK-based investor, in particular, we believe it makes sense to hold foreign currency exposure as it is a good potential hedge against Brexit-related uncertainty.

 

As we head into 2019, we’ve highlighted in our outlook that we expect volatility to increase as we head into the twilight zone. But we also see the potential for positive surprises next year, and as we’ve seen in previous cycles, calling the end to a bull market too early can be just as damaging as calling the end too late. So whilst we remain invested, I keep challenging the team to find these ‘smart hedges’, as well as opportunities for greater diversification.

 

We hope you all enjoy your Christmas celebrations. Here’s a picture before the LGIM party. Merry Christmas from the Asset Allocation team.