Your survival guide for investing in 2019

As a provider of asset allocation advice to fund managers and advisors, Brad Matthews provides an expert view of the big picture for each asset class. Weeks before 'Red October', Brad gave Livewire readers an explicit early warning in his wire offering ‘Three reasons to lighten your equity exposure'.

Speaking at a private event held by IRESS and Livewire, Brad updated us on his current views on a range of topics, with Livewire's James Marlay hosting. He discussed the two key market drivers to monitor, what he expects for the Australian economy, equity market and housing, as well as an overview of his tactical asset allocation for the uncertain road ahead. Read on for key takeouts from this highly valuable discussion, or scroll down to hear our recording in full.  

On the outlook for equities in 2019

"Clearly markets have started to get a bit nervous about 2019 and what's coming up. I think, from a share market perspective, the two key things to watch are where US bond yields go, and also where US earnings go."

"I do think that there remains potential for US bond yields to push higher. I think the Federal Reserve is being very, very transparent in the way they've approached this tightening programme. They've given the market a lot of cues."

"I think the news on the earnings side could potentially offset some negative news on the bond side, and you may see, sort of, the valuations stabilise as a result."

"But I'll be very surprised if it's an extremely strong year next year. I think markets are probably showing some heightened sensitivity to bad news, and sentiment will take a while to recover from that."

"I certainly think the October correction we saw was strongly related to rising bond yields. I think the market was starting to digest the fact that, yeah, these bond yields do have to rise. If bond yields are rising, then it does put at risk the higher levels of PE."

"I think this latest fall in share markets is probably less fundamentally driven, and is more to do with sentiment. Much of the correction that I guess we were expecting when I wrote that piece (3 reasons to lighten your equity exposure) has come through. I think we've probably got a little further to go, but I think that will be more sentiment driven than actually fundamentally based."

Why emerging markets are looking interesting

"Something else I'll be looking at closely is the status of the emerging economies, because that has emerged, if you excuse the pun, I think one area of undervaluation, one area of opportunity. Outside of [Turkey and Argentina], I think generally they're prudentially sound, and the valuation discount between the emerging economies and, say, the US share market valuations is now very wide".

Why Brad is a 'little bit more bearish' on the Australian outlook

"I think the big risk is the housing downturn. The leverage of the household sector to the housing market is very high. What we don't have is an example in the past where we've actually been through a period where housing prices have fallen by sort of 15%, 20%. If we do go through that sort of correction it creates uncertainty from a forecasting perspective because we just don't have that experience to draw on".

"Reduced construction activity is also a factor. Construction has been a big swing employer within the local economy. If you take away that driver of employment growth you start to look at a scenario where potentially unemployment is on the increase, and that creates a fairly negative outlook, I think, for the Australian economy".

"I think there is a reasonable probability that you'll get some material underperformance from the Australian market. I just don't see the growth trajectory here as being as strong as it is in the northern hemisphere. There will still be opportunities for investors, and there are still sectors in the Australian economy that aren't sensitive to the consumer or to the housing sector, but it is very dominated by sectors which are".

Getting asset allocation right is challenging

"What this chart (below) shows is the return and risk of what we call dynamic managers, so managers who invest across the broad array of asset classes, where they have a high level of discretion to move money between asset classes. And they're doing that to try and reach a return objective, and ultimately they're doing that to try and outperform a longer-term strategic benchmark, otherwise they wouldn't be moving those asset allocations around."

"It shows four years' worth of performance, and the red line that I've drawn there connects the dots of the Vanguard diversified index funds, which is effectively replicating a strategic allocation. So if all you did was invest based on a strategic framework, you would be getting a return and risk profile along that red line. Everything below that red line has really underperformed the standard SAA strategic benchmarks over the period. So it just highlights that a large percentage of the industry who are active, who are adopting dynamic or tactical asset allocation, have actually produced lower risk-adjusted returns in the index over the last four years. This shows you how tough it is".

Tactical asset allocation for an uncertain road

"We did take an underweight position in Australian and global equities. We're also underweight fixed interest there for the reasons that I've talked to before about rising bond yields. Rising bond yields mean falling values of bonds so that we're protecting the portfolio against that scenario to some extent. And we have an overweight position in cash and alternatives".

"So, particularly with the overweight cash position, we're looking for opportunities to dip back into equities at some point. It's starting to look a little bit interesting, particularly in that emerging market space. And I'd certainly have more propensity at the moment to buy into a global equity dip than an Australian equity dip for the reasons that we've talked about."

Listen to the presentation in full

Brad founded the investment consulting business, Brad Matthews Investment Strategies, which provides assistance to financial planning practices in developing their investment philosophy and creating portfolio solutions consistent with this philosophy. You can hear James Marlay interview Brad Matthews at the IRESS / Livewire event here.