Global Outlook May

Global Outlook

Tactical Asset Allocation (TAA)

The Multi-Asset team’s view on bonds, equities, commercial property and other assets affects asset allocation over the coming months. When making these asset-allocation decisions, we first consider the outlook for each asset class (e.g., government bonds), followed by views within that market (e.g., the US versus Europe, or European core economies against peripheral countries).

TAA Model Portfolio - as at 17 April 2019

TAA Model Allocation - As at 18 February 2019

Foreword

Author

Carolina Martinez, Senior Investment Analyst, Global Strategy

This month’s Global Outlook presents six different articles with a common theme: how different asset classes are navigating through an environment of changing macroeconomic conditions. This is particularly pertinent, given the very negative close to 2018.

Two important events have occurred since the beginning of 2019. First, the US Federal Reserve (Fed) paused its interest-rate hiking cycle. It did so after carefully reviewing the stance of the US economy in conjunction with the external conditions. Second, we started to see evidence that the industrial cycle in China was reacting positively to the stimulus provided by the Chinese authorities, providing support to the most important emerging economy in the world.

Markets are now pricing in a rate cut by the Fed during 2019. This is altogether a different macroeconomic scenario than the one many foresaw last year. Accordingly, this apparent new phase in the cycle poses challenges for investors, causing us to test our conviction of our current investment strategies and look for new ideas under a mid-cycle recovery phase.

In chapter 1, Dr. Jens Kroeske and Dr. Arne Staal present their framework for constructing portfolios that are outcome oriented in terms of risk dissemination and diversification. They explain in detail how successful active investing requires not only good investment ideas, but also a robust framework for managing risk. This is particularly relevant in periods where heightened volatility can cause portfolios to deviate from their expected outcome.

Andrew Milligan, examines a range of tactical asset allocation issues, identifies the strains and stresses at this point of the cycle and explains how and where we are taking risk in chapter 2.

Adam Skerry discusses the outlook for inflation on the back of the monetary policy actions pursued by authorities. He asserts that despite inflation globally undershooting central banks’ targets, economic foundations still play a key role in the outlook for inflation. As a result, he says, there are good investment opportunities - especially in the US, where he sees the larger mispricing. George Westervelt also touches on the interplay between US asset prices and the economic cycle. He argues that during the last six months there has been a clear distinction within the high yield credit market. Interestingly, the lower quality portion of the market looks to be offering the most attractive yield. However, when one takes into account the associated credit risk and the position of the cycle, caution will be rewarded. Investors should resist temptation.

Lastly, the real estate market is going through substantial changes. As some parts of the market struggle due to the changing demographics and shopping habits, so new opportunities open up. One of these is student accommodation. David Scott examines the growth in the market for student accommodation across the world.

 

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Editor

Carolina Martinez

Chart Editor

Tzoulianna Leventi

 

Managing portfolio
dimensionality

Chapter 1

Authors

Dr. Jens Kroeske, Head of Macro Systematic Strategies Research

Dr. Arne Staal, Head of Macro Systematic Strategies and Risk

Portfolio construction can have a profound impact on investment results. True diversification is difficult to measure and even harder to implement. Our proprietary approach to managing portfolio dimensionality is designed with the aim of delivering more stable outcomes for clients.

Successful active investing requires two main ingredients. First and foremost, we need good investment ideas. With skill in selecting the appropriate portfolio exposures (whether they be stocks, bonds, macro instruments, illiquid assets or individual managers) there is a strong incentive to pursue active investment management. Secondly, the importance of expert portfolio construction, which can often be underestimated. It is true that portfolio construction by itself cannot turn bad investment ideas into good ones. However, by spreading capital allocations more or less efficiently, it can still have a profound impact on investment results.pcoming election and expect volatility could provide good buying opportunities.

Outcome oriented portfolio construction

Outcome oriented portfolio construction aims to balance the exposure to investment ideas and maximize the likelihood of achieving the portfolio investment objective. Since the seminal paper on mean-variance optimisation by Markowitz (1952), this process is often implemented as a quantitative approach to maximising expected returns for a given level of risk, or vice versa, minimising portfolio risk for a given level of expected return. Often we cannot simply predict future returns with enough confidence to have portfolio weights directly depend on them in a simple quantitative optimisation. Recognising these practical difficulties of working with expected returns in an optimization setting, more recent research has focussed on risk diversification as a central portfolio construction concept. This approach aims to spread capital allocations in a portfolio such that the included investment ideas contribute to overall risk in a similar manner.

While the concept of risk diversification has become central to modern portfolio construction, the industry has not reached consensus on the ‘right approach.’ In fact, there is not even agreement on what exactly should be achieved in terms of the portfolio outcome. Most practitioners implicitly or explicitly focus on portfolio volatility reduction. This is seldom an appropriate objective on its own and can in fact encourage portfolio managers to reduce volatility by holding more cash or hedging exposures. However, clients expect active managers to maximize exposure to their investment skill in selecting suitable exposures, not to dilute their investments by investing less or in mutually offsetting ideas. At the same time, clients expect protection from losses as much as possible. This is exactly what we seek to do, and much of our research efforts has been focussed on finding the best and most robust way of doing so.

Diversification: easy to understand, difficult to measure and harder to implement

The old adage says not to put all your eggs in one basket. An easy enough concept to grasp, but one that is hard to quantify in detail, let alone leverage to your advantage in practical investment decision making. What do we consider to be baskets and how do we count our eggs in the portfolio context? Spreading risk appears sensible, but how to measure it and how do we attribute it to portfolio components?

The difficulties start in making ‘risk’ a precise statistical concept in a way that reflects asset owner’s perceptions. Volatility is the predominant measure used to characterise the uncertainty of returns on financial investments (at least in liquid public markets). It is convenient and simple to use, as the mathematics offer easily identifiable solutions. However, it is in many ways a flawed measure of uncertainty. It does not distinguish between upside uncertainty (which few investors mind) and downside uncertainty nor does it adequately reflect the potential of more extreme events. Most importantly, in our experience people care much less about volatility, than they care about real losses.

Much of the focus on volatility comes from the fact that it is an operationally convenient measure. However, this convenience comes at the price that it is only an appropriate measure for potential portfolio losses if portfolio returns are normally distributed to start with. Our lives would be much easier if this were to be the case. All investment uncertainties would reduce to a simple covariance matrix. Our main problem would become one of measuring volatility (and correlations) as precisely as possible.

Individual asset returns are rarely as well behaved as we would want them to be. The risk of unexpected large losses is embedded in all risky instruments. That is, they tend to have skewed and fat-tailed distributions. We would be negligent if we did not take this into account in portfolio construction. Diversification is the mechanism that helps us manage these risks. We can allocate to our portfolio components so that the overall outcome is increasingly similar to a normally distributed return series. This makes it easier to measure, predict and control than the individual components. We even have a precise recipe for doing so. The Central Limit Theorem is one of the fundamental tenets of statistical theory which tells us that equally allocating risk to independent return streams (or investment dimensions as we call them) in the portfolio will lead to maximum diversification.

Taking this approach allows us to quantify our portfolio expectations in a clear way. Chart 1 illustrates this for a stylized example in which we have assumed return streams with fat tails and Sharpe ratios calibrated to real world observations. The probability of loss is halved as the number of dimensions rises from one to four. More importantly, the average scale of loss, if one occurs (conditional loss, red line) also reduces from over -8% to under -4%. The result is a more than doubling in the probability of achieving a Sharpe Ratio of more than 0.75, from 30% to 75%.

Diversification is the mechanism that helps us manage these risks.

Chart 1: Diversification improves risk-adjusted returns and decreases portfolio losses

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Source: internal calculation; Aberdeen Standard Investments (as of April 2019)

These results can only be achieved if we have sufficient truly independent return streams to construct portfolios from. These are challenging to find. Investments are interlinked in complex ways reflecting the shifting preferences of multiple investor types with differing outlooks and beliefs. Similar broad macroeconomic drivers influence a number of markets, instruments and strategies. As a result they may experience losses in similar economic scenarios. For example, they may all contain some measure of broad equity market risk. Importantly, they may also offset one another – good for reducing volatility, but not useful in also generating a return! As a result, we need to recognize and evaluate these common underlying risk drivers. We can then size and group positions that reflect and isolate genuinely independent return streams that are available in our portfolio universe.

Put simply, our task as active managers is three fold. First, find as many good investment ideas as we can. Secondly, deal with the real-world limitation of overlapping underlying risks by identifying independent return streams available to a portfolio. Last, we must then size each one of them in line with the investment objective.

Measuring diversification: effective portfolio dimensionality

Measuring independent return streams within an investment universe is challenging and we have made significant research efforts to make this idea operational. We have developed a unique statistical approach, which allows us to precisely capture the notion of diversification in a metric we call effective portfolio dimensionality. Armed with this tool, we can measure the number of independent return streams in portfolios on a like-for-like basis and use it to understand likely portfolio outcomes better.

Effective portfolio dimensionality = the number of
equally sized independent return streams in a portfolio

To illustrate, we consider the example of a typical US institutional multi-asset allocation (see Chart 2). At first sight this portfolio is highly diversified. It contains a bit of everything: developed markets, emerging markets, bonds, loans, equities, etc. When we measure the dimensionality of this portfolio though, we find it contains 1.6 independent return streams. Many of the positions in the portfolio capture equity-like returns, which is the first investment dimension present. The remaining (partial) investment dimension corresponds to duration-like risk and some lesser diversifying return streams such as credit spreads. As a result, the likelihood of losses in the portfolio is driven by the equity-like investment dimension, and its associated risks of large drawdowns.

Chart 2: Typical US institutional multi-asset investment universe

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Source: internal estimtes; Aberdeen Standard Investments (as of April 2019)

Could we improve diversification for this portfolio? An obvious first step would be to size the duration component so that its overall risk impact is more equal to equities. Doing so would increase the effective portfolio dimensionality to nearly two, making more effective use of the independent return streams available. To go beyond educated guesses we need a more rigorous approach to managing portfolio dimensionality.

Managing portfolio dimensionality

To actively manage diversification levels in portfolios we need to design rules that assign portfolio weights to investment positions that result in the desired effective portfolio dimensionality. The portfolio construction approach we have developed to manage portfolio dimensionality consists of the following steps:

  1. Analyse your investment universe to understand diversification potential and find the available independent investment dimensions (we use a purpose-built ‘unsupervised’ machine learning algorithm to achieve this.)
  2. Construct sub-portfolios that align with the identified investment dimensions
  3. Weight these sub-portfolios to achieve the desired level of effective portfolio dimensionality

To bring this to life, we return to the example of the median US multi-asset allocation. We can compare the results of applying our portfolio construction approach to the same investment universe (on a rolling real-time basis). The resulting portfolio has an effective portfolio dimensionality of 2.6. This compares to the 1.6 we saw for the original median allocations and results in a much improved investment outcome.

Chart 3: Optimizing dimensionality of the median US multi-asset portfolio

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Source: ThomsonReutres DataStream, Bloomberg, internal calculations Aberdeen Standard Investments (as of April 2019)

We make two main observations. The risk-adjusted excess return ratio of the optimized dimensionality portfolio is nearly 40% larger than the ratio of the original allocation (average excess returns versus volatility stand at 0.7 and 0.5 respectively). Admittedly, it also has lower returns (5.2% versus 7.0%), but this could be addressed through deployment of leverage if needed. More importantly though, the risk of outsized losses is much lower for the optimized dimensionality portfolio. Downside risk measures have improved: for example the annualised expected shortfall has reduced from 19.2% to 8.6%.

Conclusions

Active investing needs good investment ideas and a clear portfolio construction philosophy. In our opinion, there are many valid routes to successful idea generation, including different flavours of fundamental analysis as well as data-driven systematic approaches. The same is not true for portfolio construction. There are a few common underlying diversification principles that apply to any portfolio. We believe managing portfolio dimensionality is a coherent and robust way to understand and implement these principles. In a world where risk assets have become increasingly correlated through globalization and financial policy, finding true diversification is increasingly challenging. Doing so is paramount to achieving long-term investment success.

 
Diversification is the mechanism that helps us manage these risks.
 

Proceed with caution
 

Chapter 2

Author

Andrew Milligan, Head of Global Strategy

Investors are slowly realising that there is value in many financial assets as long as the world economy can grow into 2020. However, some strains and stresses are appearing, and these will determine the next phase of the cycle.

How much risk to take in portfolios?

The answer to this question – how much risk to take in portfolios – will depend on the time scale for the investor. We are certainly positive in the short term, as we consider that financial markets are still mispricing the degree of policy easing, and the resultant benefits for economic activity in general and corporate cash flow in particular this year. Looking further ahead, however, there are various strains and stresses, both economic and political, and these should not be ignored.

After a period of panic for most financial assets at the end of last year, the first quarter of 2019 showed not only a rebound but also rather unusual returns in both bond and equity markets. Global equity markets were higher. These were led by the biggest gains for US stocks since 2009. All sectors benefitted, especially multi-nationals with high foreign exposure. At the same time, aggregate bond indices also moved higher, so portfolios delivered the best bond and equity performances since 2010. The moves in the fixed income markets were quite understandable; after all, the manufacturing sector recession in many countries, notably in much of Europe, eventually led the International Monetary Fund (IMF) to downgrade its global growth estimates to forecast the weakest outturn since 2009. As financial conditions indices turned less favourable, eventually there was a series of sharp U-turns in central bank policymaking, building on the strong signal from the US Federal Reserve (Fed).

We see further upside in 2019

Although a lot of good news has already been priced into risk assets, we see further upside in 2019. Admittedly, the first-quarter earnings season is expected to remind investors of the variety of pressures on margins, especially from labour costs. This could result in modestly negative company profits growth for the first time since 2010 (see chart 1). However, our forecasts are for a return to single-digit profits growth during 2019 as the efficacy of the policy easing in the US, Europe and especially China eventually feeds through. Monetary conditions around the world have been significantly loosened compared to expectations, and this has temporarily brought volatility down. Indeed, we expect to see more policy easing into the summer, such as (for example) interest rate and reserve requirement cuts in China. The benefits have started to appear in some business surveys, but not yet in trade data or corporate order books.

Chart 1: Economic upturn should support profits

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Source: Datastream, Aberdeen Standard Investments, (as of April 2019)

Investor positioning is a second factor to analyse. While equity prices have rallied in 2019, it has largely been a flowless recovery as capital flowed much more into fixed income, both high-yielding and safe-haven assets. The economic and political news has certainly improved in recent weeks, and this has encouraged some cash to be put to work. However, the fear of missing out remains a powerful driver for many investors to put excess cash to work, especially when the business surveys begin to move back into expansion territory, and assuming that there is eventual confirmation about a US-China trade agreement. Presidents Trumps most recent tweets are of concern here.

Strains and stresses ahead

Our analysis is already leading us to consider some of the strains and stresses that will begin to determine the next phase of the cycle. Depending on the policy responses, some could lead to positive outcomes. Most notably a reduction in political stress, causing companies to put cash to work through an expansion in business investment, would be a very positive trigger. In particular improvements in auto demand and the semi-conductor cycles would be seen as useful drivers. Other issues would tend towards building more cautious portfolios though.

The interaction between economic activity, labour markets and central bank policymaking is the first stress. The good news is that core inflation remains under firm control in the US and, indeed, on a downward path in China and Europe. However, there are warning signs from higher unit labour costs that must not be ignored, as even relatively muted rates of economic growth drive unemployment slowly lower. An assumption that the Fed does not raise interest rates in 2019 does not preclude it from acting in 2020.

The shape of the yield curve is worth examining. Although a prolonged yield curve inversion would be a warning of approaching recession, history shows that a flat yield curve can continue for some time in the later stages of a business cycle (see chart 2). But rather than focussing solely on the yield curve, it is notable that some triggers are absent this time around. Examples of these absent triggers include material tightening of credit or lending standards and a sharp contraction in the housing market, which would cause a rise in bad debts. On this occasion, we see the shape of the yield curve as signalling a slow growth environment. This again raises the thorny issue, however, of how profit margins perform; they need to be well behaved rather than seeing late cycle pressures.

Chart 2: Yield curves can remain flat for some time

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Source: Datastream, Aberdeen Standard Investments, (as of April 2019)

Another issue to monitor is the amount of money flowing into fixed income assets, which could be affected either by a central bank or a profits shock. The latest volte face by the European Central Bank (ECB) has materially affected interest rate expectations, so now about 30% of global sovereign debt, worth about $10 trillion, is negative yielding. This has serious knock-on implications for cross-border capital flows as investors are forced into higher-yielding assets. We have analysed a variety of risks, whether in the form of another growth slowdown leading to a shock to company profits through the dangers of relying on excessive leverage to achieve the necessary returns. A related factor is the drivers of the US dollar; a moderately lower US currency would possibly reflect more interest amongst US investors in buying relatively cheaper overseas assets. Low bond yields also mean global fixed income investing is increasingly driven though by currency factors as hedging costs and foreign exchange risks matter more.

There is a danger of investors getting ahead of themselves. The rise in many emerging market (EM) equity markets in recent months leaves less room for further expansion of valuation multiples. The size and efficacy of the stimulus in China, for example, is not expected to be as pronounced as in previous episodes. A number of the issues facing many company business models are structural in nature, especially the threats from disruptive technology. While the ECB gives the impression that it has ammunition left in its monetary arsenal, in reality, Europe looks to be a geared play on developments in the rest of the world.

Political risks

We remain in a world of heightened political tensions. Although the US-China trade talks appear to be making progress, we warn about two issues. Firstly, there is growing evidence of strategic rivalry between the two largest global economies, with major implications for supply chains, regulation of key sectors or cross-border capital flows, to name just a few issues. Secondly, if and when US President Trump reaches agreement with China’s President Xi, political dynamics suggest that the US will turn its attention to the trade deficit with the European Union. The run-up to the US Presidential election in November 2020 will increasingly dominate investor attention, with significant policy changes possible in such areas as healthcare, tech and banking regulation and the new Green Deal.

Looking out into, say, 2021-22, we express caution. While the base case is for continued modest economic growth, the ASI Research Institute’s recession model suggests a noticeable but not very high risk of recession in the US within 24 months. The latest IMF economic forecasts may simply have caught up with the consensus, but the IMF was right to warn about weak spots in the global financial system which could amplify future shocks. These include: the ratio of corporate debt to GDP at record-high levels in the US; European banks overloaded with government bonds; declining Chinese bank profitability, and continued low capital levels at small and medium-size lenders; and a number of EM countries continuing to suffer from high debt levels. In the coming years, we see a significant risk that populism will support the drive to protect national champions and self-sufficiency in key sectors, further reversing globalisation, trade growth and profit margins.

Our Strategic Asset Allocation model portfolio is now neutral on equities. Rather than rotating into rates and investment credit, where valuations are not attractive, instead we suggest seeking returns in EM debt, asset-backed security and infrastructure. These are higher yielding and offer some diversification from equity risk. Our view of a world of low returns, requiring more dynamic investing, remains in place. That is even before we begin to address some difficult issues about how financial markets respond to much more aggressive fiscal, monetary and regulatory policies by governments facing a populist backlash in the down phase of the next recession, as and when it appears.

Investment strategy for 2019

In assessing where next for asset prices, we consider two key questions: what is priced into the market; and why would the market change its mind. Our portfolios have benefitted in recent months as financial markets slowly realised that: global economies would avoid recession in 2019; companies could deliver positive profits growth; and central banks would not make a policy error. In combination, all of these led to a strong risk rally. It is important to be dynamic in such situations; our funds were positively disposed, but the case for further material re-rating is not compelling. Accordingly, our exposure to emerging market equities has been slimmed while we have broadened our positions in more developed markets, notably Japan and the US, where prospects look relatively more attractive. For European investors, a mix of equity income and investment grade or high yield exposure makes sense with interest rates low for the foreseeable future. Active stock picking is also encouraged – the wide dispersion of multiples is a defining feature of the global market at present.

We disagree with current rate expectations after markets priced in a Fed rate cut in 2019. Hence, we remain underweight most sovereign bonds, with a few exceptions such as Australia where the economic slowdown could influence central bank policy. Income matters in this low interest rate environment. Our portfolios continue to hold emerging market bonds and high-yield European debt. We hold the former as we are reassured about the state of most EM balance sheets and the ability of many EM central banks to ease policy. We hold the latter in the face of a Goldilocks environment of growth, inflation and central bank support in a low interest rate world. We continue to see the US dollar as a two-way market, with a balance of positive and negative drivers. Currency volatility has recently been low (see chart 3). Nevertheless, an overweight position in the US dollar provides some safe haven insurance to future shocks and provides useful carry. US Treasury Inflation-Protected Securities are similarly a potential diversifier if inflation fears appear. In conclusion, pricing out tail risks is very different from saying that a new bull market has begun – more that a recession has been avoided.

Chart 3: Narrow trading range for the US dollar

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Description: 6 month high low range as a % of starting period DXY level. DXY refers to US dollar trade weighted index
 
We see further upside in 2019
 

Inflation Deviation?
 

Chapter 3

Author

Adam Skerry, Head of Inflation

Having been largely absent through the recovery phase of the global economic upturn, inflation is showing some signs of life. Central banks have been able to conduct monetary policy with little fear of stoking up price pressure, but there are nascent signs of underlying inflation returning, particularly in the US.

The missing factor

In the aftermath of the financial crisis and in light of the subsequent monetary stimulus, inflation globally has been incredibly well contained, consistently undershooting central-bank targets, which has allowed them to keep interest rates low and policy loose. The lingering fear that ultra-accommodative policy would at some point spark an unwieldly bout of inflation has subsided, as month after month we have witnessed below-target prints, bringing into question many of the economic theories that argued against policies such as quantitative easing for fear of rampant price increases. This raises the questions of whether we are likely to see inflation return as a significant macro-economic driver and whether markets have become too complacent over the latent threat of price pressures in their outlooks and forecasts?

As the epicentre of the financial crisis, the US arguably saw the most comprehensive and aggressive form of monetary stimulus ever applied to a developed economy, squeezing bond yields down to all-time lows, whilst creating an environment that has allowed equities to steam ahead to ever-higher peaks. Similarly, real GDP growth has consistently printed between 1% and 4% since 2010, symptomatic of a healthy economy that has weathered the storms of 2007 and 2008 by dealing with many of the structural issues at its core whilst stimulating enough demand to drag itself out of the doldrums. However, this seemingly positive backdrop has only elicited a very modest pickup in inflation, when one could have reasonably expected a much higher out-turn. The Federal Reserve’s favoured core PCE measure has oscillated between 1.2% and 2.1% since early 2011, well below its mandated 2% long-run target. The reasons behind this are manifold, and have been the subject of numerous academic studies and theories exploring technology, demographics and globalisation as potential reasons for the shortfall. But of increasing importance to policy setters and market participants alike is whether these factors are likely to persist or whether there are fundamental drivers that will be the catalyst for change?

Inflation globally has been incredibly well contained, consistently

Many of the transformations initiated over the past ten years have focused on the supply side of the economy — tighter financial regulations, improved access to lending and repairing of corporate and personal balance sheets. While this was both necessary and commendable, the demand side of the economy has not followed the same path, bringing into question the long-term efficacy of recent monetary stimulus, as much of this newly generated capital has remained within the corporate sector rather than filter down into the “real” economy. However, we are now starting to see some signs of reconnect between the dynamics of the labour market and the inflationary impulses underlying the US economy. NAIRU, the concept of the level of unemployment below which inflation should theoretically accelerate, has always been a contentious issue, and the Fed’s estimates of it have often been breached to the downside with little or no sign of wage growth. What we have seen since 2014 though has been a gradual move higher in Average Hourly Earnings (3.2% yoy) and the Employment Cost Index (2.9% yoy), (see chart 1) while unemployment has drifted down below 4%, reigniting theories that the cyclical Philips Curve relationship between unemployment and wages is still valid. Such hypotheses must always be placed in the context of factors such as productivity, participation rates and unit labour costs, but the improved condition of household balance sheets (debt at approximately 80% of GDP from a high of 99% in 2008) and a monetary regime that does not appear to be pushing towards a restrictive phase make us believe there are upside risks to future US inflation prints.

Chart 1: US wage growth back towards pre-crisis levels

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Source: Bloomberg, Aberdeen Standard Investments, (as of April 2019)

Economic foundations still valid for future inflation

The degree to which this pro-cyclical view of inflation impacts specific markets will vary dramatically across regions, and, in this regard, Europe is showing fewer signs of having to face an imminent inflationary threat. Despite numerous rounds of monetary easing, policies to shore up the banking sector to help facilitate additional lending and forward guidance to assuage fears of the stimulus being withdrawn prematurely, the ECB has struggled to pull core inflation meaningfully away from 1% for more than five years. There have been pockets of wage pressure in Germany, but the inability of other European countries to push through similar increases for fear of losing competitiveness alongside a decidedly uninspiring economic backdrop means that the central bank is likely to keep a dovish bias, and a greater emphasis should be placed on expansionary fiscal policy. This may well lead to prices being dragged higher in the long term, as policy makers and governments attempt to avoid a de-anchoring of inflation expectations — similar to that witnessed in Japan — but there is little evidence currently to suggest a meaningful, structural move higher in the near future.

The introduction of new technologies and the proliferation of global trade have undeniably had a major impact on how both supply- and demand-driven inflation have evolved in recent years, and will continue to be an influence in years to come. However, we believe that macro-economic fundamentals, such as the relationship between labour markets, wage growth, fiscal policies and central-bank responses, will be crucial in determining the direction of inflation, and should not be underestimated in this post-crisis environment. Several facets of the inflation market have seemingly dismissed the risk of a sustained uptrend in price increases, whether that is in outright levels of breakevens, the flatness of yield curves or real yield prices, but where the solid economic foundations are set, we believe attractive investment opportunities continue to exist. Specifically, we advocate being long of US inflation, favour curve steepening and suggest overweight positions in US real yields.

 
Inflation globally has been incredibly well contained, consistently
 

(Still) not the time to
reach for yield

Chapter 4

Author

George Westervelt, Head of High Yield Research

Credit spreads are showing a differentiated story, while we see good fundamentals we prefer to wait for valuations to improve.

Avid readers of the Global Outlook publication will recall that just over six months ago, in September 2018, we contributed a focus piece that cautioned investors in the US high yield market against the temptation of reaching for yield by investing in the lower quality portion of the market. At that time, CCC rated bonds, the lowest rated corporate bonds, and therefore those with the greatest amount of credit risk as deemed by the rating agencies, had outperformed the overall market by a wide margin through the first nine months of 2018. Up to that point, investors’ preference for assuming credit risk over duration risk in a rising rate environment had buoyed the riskiest credits in the market. In our article, we had questioned when investor focus would return to credit risk. Coincidentally, our answer came to light just a few days later as the start of the fourth quarter marked a turning point in the performance of not only the high yield market, but risk assets globally. During the fourth quarter, the lower quality portion of the market dramatically underperformed, with CCC rated bonds generating a total return of -9.3% compared to a return of -4.5% for the overall US high yield market.

While the timing of our opinion was favourable, we cannot claim to have had a part in the unraveling of the market that led to our concerns being validated. Fears around a slowdown of global growth and the destructive potential of a possible US Federal Reserve (Fed) policy mistake gripped the market at the end of 2018. This mentality prevailed across asset classes and, as one might imagine, was particularly pronounced in US high yield. Predictably, liquidity dried up in response and prices gapped lower as portfolio managers looking to raise cash to meet redemptions were faced with a lack of buyers willing to catch a falling knife.

it’s worth pointing out that this year’s rally has been atypical

Broad-based recovery, differentiated prospects

In a dramatic reversal, the first quarter of 2019 has seen US high yield produce its best start in over 25 years, with the Barclays US High Yield Index returning an impressive 7.2% through the first three months of the year. A dovish pivot by the Fed, positive rhetoric around US-China trade discussions and diminishing fears around a global slowdown have set the backdrop for the rally. Meanwhile, strong inflows into the asset class and a digestible supply calendar have propelled returns to record levels.

However, it’s worth pointing out that this year’s rally has been atypical, considering its velocity, in that there has been very little dispersion of returns across the ratings buckets, with BBs, single Bs, and CCCs all returning approximately 7.2% during the first quarter. In our view, this is a ‘wall of worry’ scenario with investors looking to put money to work as cash balances build, but remain cautious about extending out on the risk spectrum. Taking a holistic look at the past two quarters, we can ascertain a clear picture of high yield investors’ risk appetite, with the Barclays US High Yield Index generating a positive total return of 2.4%, while the CCC cohort generated a negative return of -2.8% during the same period.

Chart 1: Option-adjusted-spread for three distinct ratings categories

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Source: Barclays Live, Aberdeen Standard Investments, (as of April 2019)

Valuations making the distinction

As the rally has been focused around quality, much of the value has evaporated from the higher rated portion of the market. This has led to what appears to be another inflection point where investors must choose between risk and safety. BB (Ba) rated bonds are trading near their post-crisis tights, offering little in the way of value to total return investors. While single Bs look to be fairly valued, what stands out is the opportunity for upside in the CCC (Caa) portion of the market. This offers an enticing combination of both higher income and the potential for meaningful spread compression from current levels.

A word of caution

As we did in September, we would once again caution investors against being seduced by yield at this point in the credit cycle. While positive technical factors, like lack of new supply and high demand from investors, have supported the market so far this year, we view this as a temporary phenomenon. This is particularly the case in the riskier subsection of the high yield market, which consists of a smattering of idiosyncratic credits that will ultimately be driven by company-specific fundamentals. All in all, at current valuations, we don’t believe investors are being compensated for the downside. Why risk eroding what has been a stellar year in terms of absolute performance by piling into illiquid credits that lack fundamental support?

Wait for valuations to catch up with good fundamentals

This isn’t to say that CCCs will not catch a short-term bid and close the valuation gap illustrated in the chart. In fact, we’ve already seen early indications of this over the first two weeks of April as high yield portfolio managers scramble to invest retail inflows. However, our sense is that the capitulation by investors to edge out on the risk spectrum isn’t being done due to fundamental convictions. After a long string of inflows, managers have cash to put to work and seemingly nowhere else to go for value other than CCCs. This is a potential value trap in that the ability to be nimble in the lower quality portion of the market can be non-existent in times of stress, leading to a group of investors looking to fit through one small exit door in an attempt to reposition portfolios. While the yield pick-up is tempting, we would advise investors to take a longer-term view, reserving dry powder for a better entry point while patiently remaining on the sidelines until both fundamentals and valuations support the investment thesis of adding credit risk.

 
it’s worth pointing out that this year’s rally has been atypical
 

Student Accommodation: where are the growth
opportunities?

Chapter 5

Author

David Scott, Senior Real Estate Investment Analyst (UK)

Investors have been increasing allocations to purpose-built student accommodation assets in a handful of developed markets where there are still many opportunities to develop.

The growth of the purpose-built student accommodation market

The student accommodation sector has experienced significant global growth over the last decade. Investors allocated a total of $17 billion into the sector in 2018, approximately 55% above the long-term average investment level. North America and the UK accounted for 65% and 25% of transactions respectively, whilst Europe ex-UK made up a much smaller proportion of investment activity as the sector is still in its infancy in this market. Allocations to the student accommodation market have been driven by a favourable demand/supply imbalance in most major cities as well as the diversification benefits. This is largely a result of the more resilient returns the sector has historically exhibited during periods of market stress, and more consistent cash flows given the multi-tenanted nature of this asset class.

Global institutional investors are now turning their attention to continental Europe

Drivers of growth

The development of the student accommodation market is intrinsically linked to the growth in international student numbers. For the host countries, international students are an important source of income, often paying higher tuition fees than domestic students and contributing to the local economy through their living expenses. The flow of international students has been far from uniform, with English-speaking countries attracting the largest share of an increasingly fluid global student population.

The US is the top OECD destination country for international students, hosting 28% of the 3.5 million international students in the OECD area. The UK and Australia accounts for 12% and 10% respectively. The US is home to 11 of the top 20 universities globally. Perhaps unsurprisingly, it is the most developed purpose-built student accommodation market. Capital flowing from the US has also been a major driver of growth for the student accommodation sector in other jurisdictions, and the UK has been a key beneficiary of this trend.

Where next?

Seeking out higher returns and better growth opportunities, global institutional investors are now turning their attention to continental Europe as the student accommodation markets in the UK and the US mature. The market is nascent and the provision of student accommodation across Europe at the national level remains low relative to more established markets. In the UK it is estimated that 33% of students live in purpose-built accommodation. This is in stark contrast to France, where it is estimated that this figure is closer to 15%, whilst in Italy it is as low as 2%. The under-provision of student accommodation in a number of European cities is clearly a key attraction for investors.

The relative immaturity of student accommodation in some markets can be best explained by a greater tendency for domestic students to study locally or to decide to live at home. One potential source of future growth in demand for student accommodation lies with international students, and the belief that trends that have played out in the UK will play out in Europe. International students commonly cite the improvement of language skills, particularly English, as a key motivation for studying abroad. With this in mind, the number of English Taught Programmes (ETPs) in Europe increased from 500 in 2007/08 to over 6,000 in 2014/15, according to the Academic Cooperation Association. The hope for many investors is that the increase in ETPs will result in a greater number of international students, and that this will translate into greater demand for student accommodation. However, at this point there is little evidence to demonstrate an increase in demand.

Chart 1: Distribution of international students in tertiary education, by country of destination

insert_chart
Source: OECD, Aberdeen Standard Investments, (as of April 2019)

Knowing your local market

Having a deep understanding of the local market environment is of critical importance for the student accommodation sector. The level of service and amenity provision is particularly pertinent as a ‘one-size-fits-all’ model simply doesn’t exist. In Spain, and to a lesser extent in Italy, it is commonplace for meals to be included with the rent. This is in contrast to Germany and the UK where meal provision is not standard practice. Ensuring that the investors are aware of each individual market’s amenity expectations is crucial to be able to attract and retain students, particularly international students who often have very different amenity expectations. Failure to do so can materially impact the net operating income of an asset.

Summary

The weight of global capital targeting the student accommodation sector remains sizeable and there are few indications that this trend will slow anytime soon. In the hunt for new growth opportunities, attention is now turning to Europe, where there are a number of appealing facets, not least the low penetration rates of student accommodation relative to the more established markets of the UK and US. However, a student accommodation concept which works in one jurisdiction might not be readily transferable to another. Hence, understanding the local market and the level of amenity provision is crucial to ensure that returns for any investment in the sector meet initial expectations.

 
Global institutional investors are now turning their attention to continental Europe

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Risk warning

Risk Warning

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.