Navigating turbulent times
We expect the investment cycle to be extended into 2020-21, with the support of significant central bank easing. Nevertheless, in the face of worsening valuations and political headwinds, a more tactical and opportunistic approach is required.
Good performance into the summer
It is often the case that financial assets perform well after a period of intense disappointment. In mid-July, the US S&P 500 index broke through the 3,000 level, achieving a new high. This caps exceptional performance for both equity and bond markets. In many cases, these showed the best performance in the first half of a year since 1997. To put these figures into perspective, at its worst point in Q4 2018, the global stock market was back at levels last seen two years earlier.
Market valuations have encouraged a reassessment of the next phase of the investment cycle.
It is no surprise therefore that many surveys of investor positions show a degree of profit-taking over the summer. Indeed, market valuations have encouraged a reassessment of the next phase of the investment cycle. It is true that valuations look stretched in certain parts of the bond and equity markets. Put another way, under what circumstances would current valuations be justified?
To consider a few examples, with benchmark US bond yields at about 2%, then to all intents and purposes the real return is likely to be zero unless a deflationary environment appears. The interest rate structure has altered yet again in Europe and Japan, so that roughly 40% of all government bonds and almost 25% of corporate debt is now negative-yielding.
Turning to equities, the price/earnings ratios of the major markets are high rather than extended, generally in a band of 15-20. However, this is against the backdrop of a noticeable slowdown in corporate profits growth and concerns about an approaching squeeze on company margins. Labour costs are the main issue, given very moderate top-line sales growth and, in many cases, a rising regulatory burden.
It may be a case of ‘better to travel than arrive’, but certainly the forthcoming easing of monetary policy by the major central banks is providing considerable support for both bonds and equities. For some time, the People’s Bank of China (PBOC) has been easing, albeit via the interbank lending rate rather than the official PBOC rate, alongside a degree of fiscal support such as income tax cuts. Stability matters significantly in this important anniversary year for the Communist Party.
The latest statements from the US Federal Reserve (Fed) show that it has accepted that it must align with the monetary easing priced in by the bond markets; we expect to see two rate cuts during the second half of 2019 (Chart 1). The Fed is talking in terms of insurance policy moves designed to extend the business cycle, especially in an environment where dis-inflationary pressures are apparent.
Chart 1: Low expectationsSource: Bloomberg, Aberdeen Standard Investments (as of 15th July 2019)
In many senses, the most significant U-turn has been by the European Central Bank (ECB). Earlier this year it was strongly hinting at raising interest rates in 2020; now it is signalling not only at taking official rates further into negative territory but also restarting its quantitative easing (QE) programme. This has resulted in a considerable flattening of yield curves across Europe amid preparations for a sizeable amount of bond issuance by governments and corporates anticipating a borrower of last resort (Chart 2).
Chart 2: Flattening curvesSource: Bloomberg, Aberdeen Standard Investments (as of 15th July 2019)
On top of a revaluation effect as the long-term discount rate has taken another step down, investor positioning and cross-border flows have supported financial market pricing. The recent unexpected announcement from President Trump that he was opening a new front with Mexico in the trade wars caused many equity investors to capitulate and rush into cash. A change of stance on trade, towards both Mexico and then China at the G20 conference, reassured investors that the US was not making a major geopolitical mistake. This was subsequently over-turned by the recent announcement of new tariffs of China. Earlier in the year, investor capital had flowed into money-market funds when the Fed appeared to be on the path of rising rates. Much of that capital appears to be moving into high-yielding fixed-income assets in a world of low or negative interest rates.
Our portfolios remain risk-on but we have become both more cautious and more diversified into the summer. This reflects our assessment of what is in the price, the imbalances, strains and stresses in the world economy, and the likely efficacy of the monetary policy response.
Some risks are undoubtedly economic. In the first half of 2019, the mini-recession in the manufacturing sector has become very apparent (Chart 3). Global trade growth has fallen back to about zero, while poor business confidence is discouraging capital spending. Surveys suggest little improvement in activity into the early autumn. The good news is that the world economy is holding up, thanks to solid consumer spending and expansion in the services sector. Our economic forecasts are for global GDP growth of about 3% per annum in both 2019 and 2020. In effect, as long as the credit and corporate bond markets remain open, then we see the flat or modestly inverted yield curve as a sign of slow growth rather than imminent recession. Looking ahead, a downside risk would be job cuts from manufacturing undermining household consumption. Upside risks would reflect improvements in business and consumer confidence, encouraging more spending on durable goods and capital expenditure.
Chart 3: Manufacturing slumpSource: Markit, Bloomberg (as of June 2019)
Such a forecast for economic growth reflects our assumptions about how much monetary and fiscal easing will materialise in the major economies in coming months. A second concern, then, is how effective such steps will be. On the one hand, a reduction in borrowing costs should support, for example, the housing markets and real estate sectors in many countries. On the other hand, the benefits could be offset by a rapid reversal of the recent rapprochement in US-China trade tensions. There are very mixed messages from politicians in both countries about the final details of a difficult negotiation. At the same time, investors are concerned that the US could open a new front with the European Union (EU) in an election year. Meanwhile, the trade tensions between Japan and South Korea are a reminder that other governments are now ready to use the threat of tariffs.
Even if the trade truce continues, investors are now increasingly aware of the growing strategic rivalry between the US and China. At one level, this dampens business and investor confidence. At a more granular level, it is encouraging firms with China operations to reconsider their supply chains. There will be winners – India, Korea, Taiwan and Vietnam are the most obvious among the emerging markets (EM) – but also losers. For example, higher costs and duplication of production lines would create another headwind to company profits growth.
Policy errors are dangerous late in the investment cycle. Currency stress would be an obvious channel. Although most currencies have seen modest volatility so far in 2019, with the exception of sterling and some EM, we are analysing moves in the US dollar and Chinese renminbi closely. Sharp changes in either could once again put many EM assets under stress, at a time when a number of EM central banks hope to cut interest rates in coming months.
Despite the G20 accord on trade, we remain in a world of heightened political tensions. The EU Parliamentary elections have led to a more fractured situation, which reduces the likelihood of major structural reforms. Italy and Brussels have agreed that the budget outcome is satisfactory for 2019, but not for 2020 onwards. The decline in the dollar/sterling exchange rate towards 1.20 suggests that more investors are pricing in the risk of a ‘hard Brexit’ outcome. The price of oil is fluctuating, partly on normal supply/demand issues but especially on worries about growing tensions between the US, Iran and other countries in the Straits of Hormuz. Looking further ahead, significant policy changes are possible after the 2020 US elections in such areas as healthcare, technology and banking regulation, or the Green New Deal economic stimul package.
Investment strategy for 2019-20
Although global equities form the core of our portfolios, we emphasise that more diversification is required to gain the benefits of other risk premia. We prefer developed to EM equity. Positive profits growth will support both regions, but EM equities have greater risks related to trade barriers or currency volatility. Within EM equities, we favour Asia, on the grounds that any further stimulus from China should support that region.
Interest rate cuts are a good backdrop for holding assets with yield, carry or spread. One approach is to hold high-yielding corporate bonds, which we do in both the US and Europe. In addition, we have positions in EM debt. Investors need to be selective, but the problem countries like Venezuela or Turkey do not dominate those markets. However, taking too much risk in fixed-income markets does not make sense when bond valuations are rather stretched. Stronger-than-expected economic reports can significantly alter market expectations. Hence, we are underweight low-yielding Japanese and US government bonds in our portfolios.
Alternative assets can of course provide income in a world of low interest rates. Real estate is one example, although again care must be taken. The retail sector is under pressure in many countries, noticeably the UK and the US, owing to the inexorable rise of e-commerce. Conversely, there is strong demand for office space, data centres, logistics sites, hotels, and student and residential accommodation in many economies.
In relation to currencies, valuation models are not giving strong signals. Some EM currencies are expected to see moderate weakness in coming months, as interest rate cuts take effect. The dollar is likely to drift lower as fgrate cuts by the Fed reduce its carry attractiveness. The one currency that could prove volatile is sterling, of course. A Brexit shock could easily see the pound test previous lows against the dollar and euro in coming months.
In terms of investment style, we see the year ahead as one where more tactical decisions will make sense. We expect to see sharp rallies and sizeable sell-offs as global investors react to a complicated mix of economic, corporate and political signals. In these circumstances, a diversified portfolio makes sense, as does having cash to put to work as and when value appears in any asset class.
Market valuations have encouraged a reassessment of the next phase of the investment cycle.