Global Outlook October

Author

Jennifer Mernagh, Investment Director, Multi-Asset Solution

Foreword

The third quarter remained difficult in many respects, but the global economy showed marked progress emerging from the economic contraction we experienced in the spring. Faster than expected improvement led economic forecasts to be revised upward and is in part behind some of the strength that equity markets witnessed in the period. That said, output for the full year in GDP terms will remain at depressed levels and show the worst year-over-year contraction in decades.

The global economic recovery has now slowed as further waves of coronavirus infections and their impact are felt. In addition fiscal support on offer to businesses and households alike is coming to an end, which could have a negative impact on markets.

So what are we currently focusing on in terms of the future path? Some of the waymarks we are monitoring include: a different timeline for the successful development of an effective vaccine; the longevity of fiscal support for economies; and the outcome of the US election.

Rightly much attention is being paid to the upcoming election and it is a key focus of our investors and clients. With just weeks to run, the campaign is intensifying but the outcomes aren't yet certain. At the time of writing, most polls suggest a lead in national and several swing states in favor of former Vice President Joe Biden. If he wins there will by definition be a break with the status quo, but ultimately we suggest caution in extrapolating that platform policy measures will be enacted, in particular if there remains a split congress. We will update you as our views evolve but the notion that the market would be ‘surprised’ by this outcome is exaggerated in our view and the key impacts will take months if not years to manifest.

Thomas Leys, Investment Manager, Fixed Income Research, discusses data centre company bonds in the context of carbon emissions. Thomas describes the environmental impact of the amount of data we consume as a global population, and compares it to other industries such as transportation. He describes how the industry has gained efficiencies over the last decade, and how some companies are moving to renewable energy sources as a way to address political and investor concerns regarding their environmental impact.

Lucas Tan, Senior Analyst, APAC Real Estate Investment Research, discusses the increasing need for last mile fulfilment centres in Australian cities. Historic changes to town planning approaches by local government in Australia led to a bottleneck around delivering goods and services. However, changes are being made to unwind these inefficiencies to benefit residents in urbanised areas. Until recently, the logistics market has been dominated by private investors and owner occupiers, which has been less well understood by institutional investors. Lucas argues that investors should consider this asset class as it offers the potential for increased yields and capital appreciation.

Carolina Martinez and Alistair Veitch, Co-Chairs of our Emerging Markets Asset Class Steering Group within Multi-Asset Solutions, give a holistic view of the markets they consider. The response to, and consequent impact of COVID-19 has led to divergent performance of China and South Korea versus Latin American countries, which have suffered a great deal from this pandemic. Differing fiscal and monetary responses, dictated by the financial health of each country, have also led to differing vulnerabilities, and therefore performances within these markets. As a result, the team's focus is on understanding the differentiated outcomes, and expressing granular views within portfolios.

Finally, Eimear McKeown, Justin Kariya, Gerry Fowler, members of our FX Asset Class Steering Group within Multi-Asset Solutions, give their views on the outlook for the US dollar and other major currencies following a period of significant volatility. Our expectation of low yields over the long term mean that on balance our view is that the USD continues to remain weak, although the trend down is likely to be less pronounced from here. The low rate environment in the US benefits other currencies such as the Japanese Yen as well as certain emerging market currencies where valuations appear to be attractive, although the team is sensitive to the structural fragility of some of these economies.

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.
 

Data centres and climate change: a silver lining to cloud computing for investors?

Fixed Income ESG

Author

Thomas Leys, Investment Manager, Fixed Income Research

Is watching half an hour of Netflix as bad for the planet as driving an ordinary car four miles? So claimed online blog Big Think in October 2019 in a story that quickly made the headlines. Most consumers will be unaware that their video streaming and cloud computing habits are facilitated by energy-hungry data centres all over the world. Estimates vary, but in 2018 data centres globally may have consumed as much as 400 terawatt-hours of electricity1 – roughly the same as the entire demand of France. As two thirds of global electricity production still comes from fossil fuels there is a danger that our insatiable demand for data becomes incompatible with efforts to mitigate climate change. With data centre company bonds worth $47 billion is this something investors should be concerned about?

In simple terms, data centres are buildings that house tens of thousands of servers containing large quantities of information and connect these to the wider internet. To access and process this information requires energy and to prevent the servers from overheating requires even more energy. One of Equinix’s New York data centres has 182.5 megawatt back-up generators2 – each capable of powering a small town. This explains how five billion YouTube views of Justin Bieber’s song, Despacito, consumed the same power as 40,000 US homes do in a year3.

When pitching to investors, data centre landlords find no shortage of future growth sources. Increased cloud computing, higher quality and quantity of video streaming, 5G, increased smartphone adoption worldwide, the Internet of Things, autonomous vehicles and artificial intelligence are all listed. History suggests they are not exaggerating: in 1992, the world consumed 100 gigabytes of data a day. Ten years later this was consumed every second. Cisco estimates that by 2022 the world will consume 150,700 gigabytes a second, increasing at a rate of 33% each year4.

These demand forecasts have lead many observers to claim that data centres will soon overtake the airline industry when it comes to carbon dioxide emissions. Anders Andrae of Huawei expects them to consume as much as 8% of global electricity demand by 20305. This comes at a time when the world is seeking to reduce energy consumption and the related greenhouse gas emissions. Will investing in the data centre sector increasingly be seen as a reckless contribution to climate change?

Efficiencies continue to be found

There are reasons for optimism. First, increased data consumption does not equate to increased power consumption. Named after the Stanford professor who published work on it, “Koomey’s Law”6 states that the energy intensity of a gigabyte of data delivered via data centres halves every two years. This is supported by Google’s experience, whose data centres today deliver seven times as much computing power using the same electrical power as they did five years ago7. Increased computing efficiency, better cooling systems and artificial intelligence to direct power are some of the many ways in which this is achieved. When Digital Realty, the largest data centre landlord in the world, moved from water cooling to refrigerant pumps in its Californian data centres it saw a 13% reduction in energy use along with a 4.4 million reduction in annual water use in each property8.

Strong incentives are in place for this to continue, both for equipment manufacturers and data centre operators, who are used to saving power in order to reduce costs and meet the sustainability objectives of their clients. Contrary to the alarming forecasts made by Mr. Andrae, a paper published in Science in February found that the proportion of electricity consumed by data centres is the same today as it was in 20109. So data consumption may continue to surge without driving up power consumption and emissions.

Data centres remain highly energy intensive and will face pressure to ensure this does not translate into excessive greenhouse gas emissions

Still, even if the sector manages to avoid a boom in electricity consumption, data centres remain highly energy intensive and will face pressure to ensure this does not translate into excessive greenhouse gas emissions. Take Digital Realty, the only data centre company to issue green bonds: in 2018, the power it purchased emitted 720 tonnes of CO2 (equivalent) for every million dollar of revenue at the company. This is double the average emissions intensity of the gas industry and just 20% less than the airline industry average. However, unlike these, and other traditionally ‘dirty’ sectors, data centres have a clear and viable route to slashing their emissions to zero: renewable energy.

The journey to lower emissions

Recognising this, Digital Realty has moved its entire European portfolio to renewable energy sources and set a goal of making it available to customers across all 275 data centres it owns. Having 324 megawatts of wind and solar projects under contract in the US will help10, but around 70% of the company’s data centres continue to be powered by fossil fuels. This still compares favourably to smaller US-focused rival, CyrusOne, who has no renewable energy targets and is yet to report on its business’s carbon emissions. On the other hand Equinix, which also operates over 200 data centres, has an exemplary track record. Despite doubling the size of its portfolio in the last five years, it was able to move from 33% renewable energy (similar level to Digital Realty) to 92% today11. This helps explain how Equinix’s purchased power emissions are over 90% lower than Digital Realty’s. The carbon footprints of data centres can therefore be dramatically reduced relatively quickly, particularly as renewables are increasingly the cheapest source of power.

The international rise in public concern over climate change has pushed it to the top of many policy-makers’ and investors’ agendas, with scientists reiterating that this needs to be the decade of change. Data centre company bonds have, on average, over six years left to maturity and some are as long-dated as 30 years. Over this period, it is inevitable that pressure to move away from fossil fuels will intensify from customers, regulators and investors. Identifying those issuers that are proactively lowering their emissions today is vital for bond investors assessing credit risk. Equinix and Digital Realty fit this profile, supporting our overall positive view on the companies and their bonds.

Our insatiable appetite for data is not going to slow down, but computing and data centre efficiencies will keep energy demand at bay. Data Centre Knowledge calculates half an hour of Netflix streaming today as equal, in terms of emissions, to driving a car 460 feet12 – not four miles. Meanwhile, the increased adoption of renewable energy by data centre companies will cut this further. This is something which should be welcomed and encouraged by investors, who may eventually be able to binge-watch Netflix guilt-free.

1 https://www.researchgate.net/publication/339900068_Hypotheses_for_primary_energy_use_electricity_use_and_CO2_emissions
2 https://www.datacenterknowledge.com/archives/2016/04/19/ny4-inside-equinixs-crown-jewel-new-jersey
3 https://fortune.com/2019/09/18/internet-cloud-server-data-center-energy-consumption-renewable-coal/
4 https://davidellis.ca/wp-content/uploads/2019/05/cisco-vni-feb2019.pdf
5 https://www.nature.com/articles/d41586-018-06610-y
6 https://onlinelibrary.wiley.com/doi/full/10.1111/jiec.12630
7 https://www.blog.google/outreach-initiatives/sustainability/data-centers-energy-efficient/
8 https://go2.digitalrealty.com/rs/087-YZJ-646/images/Case_Study_Digital_Realty_1607_Emerson.pdf
9 https://science.sciencemag.org/content/367/6481/984
10 https://go2.digitalrealty.com/rs/087-YZJ-646/images/Report_Digital_Realty_1906_Environmental_Social_Governance.pdf
11 https://cloud.kapostcontent.net/pub/d9669014-7b74-490d-ad4d-c0795de0a981/sustainability-report-2019-1
12 https://www.datacenterknowledge.com/energy/how-much-netflix-really-contributing-climate-change

Data centres remain highly energy intensive and will face pressure to ensure this does not translate into excessive greenhouse gas emissions
 

Australian urban industrial sector

Real Estate

Author

Lucas Tan, APAC Real Estate Investment Research

The process of gentrification (up-and-coming areas) in major Australian cities brought about heavy utilization of city infrastructure. Higher population densities and greater required service levels are driving increasing demand for urban industrial space.

Defining Australian urban industrials

Unlike other developed nations, Australian urban industrial assets have not historically been at the top of institutional investors’ minds. This is evident from the high levels of private ownership and the individualistic scale of the investments. We define urban industrial assets as having the following characteristics:

  • Less than 15,000 square metres in land area
  • Located in land-constrained clusters/areas, with limited available greenfield development opportunities
  • Proximity to major residential populations, sizeable commercial hubs and major transport nodes
  • Owned by a good mixture of private/owner occupiers
  • Greater diversity in the range of tenant uses

The increasing need for urban industrials

Rapidly expanding and physically constrained cities result in an increasing and competing need for land. From 2000 to the mid-2010s, Australia’s planning authorities took the view that central industrial space would become obsolete. As such, they initiated a massive rezoning of inner-city industrial land to mixed-use residential development. The rezoning effort led to densely populated Australian cities. From a real estate perspective, accelerated gentrification (up-and-coming areas) reduced the amount of urban industrial space. The government has since changed its stance after it realised that urban industrial space is essential for a well-functioning city. Urban industrial space eases the burden on infrastructure and better satisfies modern-day inner-city demands. Thus, a pullback in rezoning effects.

Chart 1: Urbanisation rate across countries

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Source: CIA Factbook, Aberdeen Standard Investments, (as of 2020).

In the past, the logistics supply chain consisted of two steps: goods flowed from larger satellite distribution centres to town distribution centres, before reaching consumers. Now cities are more densely populated, there is a larger city footprint. Businesses and consumers also have increasing service-level expectations. More convenient delivery options and higher efficiency solutions have increased the volume of deliveries. These deliveries require resources, such as vehicles, roads and drivers, and it all starts to become uneconomical, inefficient and unsustainable. Thus, the supply chain evolved, with a third link to alleviate the situation: last-mile fulfilment centres that serve businesses and consumers alike.

Growing demand for Australian urban industrial space

Issues brought about by rezoning have prompted greater demand amidst lowered supply of urban industrial space. Firstly, a large number of tenants had previously relocated due to the withdrawal of urban industrial stock. Secondly, more intensive land use led to a substantial increase in permanent residential populations that are close to major business districts. Now, previously displaced tenants/building owners are competing for a diminished number of remaining industrial assets. At the same time, the business advantages of being close to population nodes are increasing the demand for these spaces.

Demographic trends point to an increasing concentration of last-mile deliveries in urban areas. This is significant for Australia, as it ranks among the world’s top 30 most urbanised countries. Urban logistics is not something new for Australia. However, the existing network serving industrial businesses and bricks-and-mortar retail has to evolve further to cater for ecommerce, online retailing, and door-to-door delivery. Tenants in strategic locations can provide higher service standards, which lead to higher business revenues/profits and bigger budgets for higher rents.

Land constraints limit supply

These urban industrial assets sit within industrial clusters close to residential areas, commercial hubs, or key transport nodes. Such built-up locations face geographic limitations to expand outwards, resulting in a land-constrained supply situation. The other option is to extend upwards. However, this tends to be limited as ramp-up or multi-level warehouses require certain land sizes. These might not yet be physically possible or financially viable.

An example of a supply constrained sub-region would be Sydney South. From 2015 to 2020, this sub-region averaged 6,600 square metres of new supply a year, or a 0.5% net increase each year. In contrast, the wider Sydney market averaged 556,000 square metres of net additions a year. This represents a 4.5% increase to total stock each year.

Australia’s urban industrial sector has a backdrop of increasing demand set against limited supply. This points towards a favourable investment climate

Australia’s urban industrial sector has a backdrop of increasing demand set against limited supply. This points towards a favourable investment climate. We expect rents to grow at a faster rate and for capital value gains to be possible in the future.

Australia’s urban industrial sector has a backdrop of increasing demand set against limited supply. This points towards a favourable investment climate
 

Delicate and divergent: the recovery in emerging markets

Emerging Markets

Authors

Carolina Martinez and Alistair Veitch

With no major country escaping its ravages, the Covid-19 pandemic has had a profound impact on the physical and economic health of the world’s emerging markets (EMs). But that impact has been uneven, both in its timing and in its extent.

Vulnerability: the key differentiator

Across EMs as a whole, new cases of Covid-19 are still growing by the day. But while many countries are struggling to control the virus, certain Asian nations already have their economic recoveries well underway, although they are not free of risks.

The standouts in the management of the health crisis are China and South Korea. These countries were exposed to the virus early on, but dealt with it decisively, through draconian lockdowns in China’s case and efficient testing and tracing in Korea’s. In contrast, Brazil, India and South Africa have struggled the most – and continue to do so.

Most EMs bore the full brunt of Covid’s economic impact during that quarter. Many have registered double-digit declines

This has led to starkly divergent economic outcomes. China returned to growth in the second quarter while South Korea contracted only slightly. But most other EMs bore the full brunt of Covid’s economic impact during that quarter. Many have registered double-digit declines.

Monetary and fiscal policy is another differentiating factor and has been critical in determining the pandemic’s economic impact and shaping the probable course of recovery. In general, EMs have adopted a ‘developed-markets-light’ approach, employing both monetary and fiscal policy tools.

For some countries, those tools have proved less effective than in the developed world. But, more importantly, the degree to which they can be used is a function of financial vulnerabilities. Concerns about balance of payments and currency weakness loom large here and limit countries’ ability to act. Given these limits, many central banks have already fired most of their bullets. This means that the relative financial health of individual countries will lead to further divergence in economic outcomes.

Chart 1: Vulnerabilities ranking

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Source: Refinitiv Datastream, Aberdeen Standard Investments, (as of September 2020).

We’ve been monitoring countries’ flexibility through our proprietary ‘vulnerability score card’ (Chart 1). This is a ranking tool that covers many fundamental economic and financial variables. The key message that we’re getting is that countries’ room for manoeuvre varies widely, which will again lead to varying economic outcomes, especially in foreign exchange, one of the most sensitive financial assets for economic development and market expectations.

What’s in the price for EM assets?

Clearly, Covid’s varied economic impact has affected corporate earnings accordingly. Before the pandemic, expectations for earnings growth in the next two years were fairly similar for both emerging Asia and Latin America. In each case, the consensus view was for earnings growth of around 30% over that period.

But the pandemic has unveiled Asia as the clear leader. There has been only a modest deterioration in expectations for Asian earnings. And, crucially, our top-down macroeconomic modelling aligns with analysts’ bottom-up projections for corporate earnings (Chart 2).

Chart 2: Earnings per share (EPS) % growth estimates for 2021/2019

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Source: Refinitiv Datastream, Aberdeen Standard Investments, (as of September 2020).

In contrast, earnings in other EMs are not expected to have fully recovered by the end of 2021. Even so, we think that some expectations may still be too high. In particular, we’re concerned about a disconnection between earnings expectations and the growth outlook in Latin America. Our top-down model is signalling that consensus earnings expectations are too high. So we see the potential for disappointment if economic growth plays out as we expect.

And what about valuations for other EM assets? Our analysis shows that most investment-grade credit spreads and bond yields are near the lower limit of their five-year range or close to their pre-Covid levels. Meanwhile, currencies, high-yield credit spreads and equity earnings yields are still lagging the recovery in investment-grade corporate debt and sovereign debt.

Investors' behavior is another relevant aspect to note. So far, foreign investors have not been the major driver of rebound in EM assets. Year-to-date equity outflows have been very sharp, and there’s also been a marked deceleration of inflows to EM debt. More recently, as confidence improves, we are seeing seen signs that this is starting to change. Interestingly, the equity market has managed to rebound despite the outflows of foreign capital. That suggests that local investors are driving the current rally. The recent slowdown in foreign outflows is positive, but we’d need to see it sustained to have confidence in foreigner investors’ re-engagement.

Putting the pieces together: macro outlook, monetary policy, valuations and investors’ behaviour

On the macro side, we are mindful of not confusing a rebound with a genuine recovery. So although we’ve upgraded our macro view, this is not sufficient to give us a positive outlook on most EM economies, as our vulnerabilities screen suggests. We expect monetary policy to remain accommodative, but we see only marginal improvements from here: again, the authorities don’t have much ammunition left.

Finally, as investor sentiment has improved, valuations look less appealing. All of this leaves us with an outlook for EM assets that is modestly positive overall. We still have a preference for sovereign debt and equity over corporate credit and foreign exchange.

However and more importantly, there are some interesting opportunities within asset classes. At a more granular level, we have a preference for local-currency debt over hard-currency debt. We also prefer Asian assets, including currencies and equity, to those from other EMs, given Asia’s greater exposure to technology and internet-related businesses, and its stronger macroeconomic position. Meanwhile, Latin American markets are our least preferred for currencies and equities.

Adjusting our portfolios accordingly

Given this, it’s fair to say that in many of our Multi-Asset portfolios our current notional exposure to EM is lower than normal. This is because developed markets currently offer more attractive risk-adjusted returns.

We do, however, remain well exposed to EMs across a number of strategies. Within these, we’re focusing on relative value to exploit the differentials between countries and economies using our vulnerability scores. In EM equities, we don’t advocate broad exposure. Instead, we’re focusing on China and South Korea, where economies are recovering well. We also have additional EM company exposure in our global thematic strategies.

Meanwhile, we remain invested in EM corporate debt, although we have been reducing our exposure into the rebound. In local-currency sovereign debt, we have been fully hedged the currency until very recently, when we began to reduce that hedge. We favour currency-hedged South African bonds, which are high yielding, and Chinese bonds, which we see as an attractive lower-yielding investment.

The recovery roadmap

As we move forward, our risk appetite and positioning of Multi-Asset portfolios will depend on the balance of several risks. In order to favour cyclicals over defensives and equity over local-currency debt, we would need to see an ongoing decline in currency volatility, continued accommodative monetary policy and clarity from governments as to how they will fund the spending packages that have been announced, a decline or plateau in hostility between the US and China, a fall in Covid infection rates in EMs, and a broadening of the economic recovery.

Overall, we think that while the EM recovery will continue, it will be delicate and divergent. Emerging markets have never been a homogenous bloc, and the Covid-19 pandemic has shown their divergences in sharp relief. For investors, of course, these differences are opportunities – and we’ll continue to focus on those granular distinctions in the months ahead.

Most EMs bore the full brunt of Covid’s economic impact during that quarter. Many have registered double-digit declines
 

Currency Ups and Downs

Currencies

Authors

Eimear McKeown, Justin Kariya, Gerry Fowler, Multi-Asset Solutions

Back in March 2020, with coronavirus spreading and liquidity uncertainty hitting its peak, demand for the US dollar soared and the currency rose around 7% from where it started the year. However, in recent months, the dollar has fallen 10% to the lowest levels we have seen in more than two years. The investor narrative has shifted from a ‘dash for US dollars’ to speculation about a longer-term dollar downtrend. Has the coronavirus pandemic marked the dollar’s final peak before reversal? We have reviewed the key drivers of its moves this year and believe there are still multiple cross-currents influencing its trajectory. Nevertheless, risks are still tilted to further US dollar weakness over the next six-to-12 months, in our view.

Interest rates lower for longer

The US dollar has been declining steadily in recent months, in line with the sharp decline in US nominal and real yield levels. After aggressive rate cuts and significant balance sheet expansion by the Federal Reserve, we have seen US two-year yields decline 150 basis points (bps) and ten-year yields decline over 100bps. These moves have been significantly larger than the yield decline in other major economies such as Europe, the UK and Japan.

Lower relative yields deter income-focused investors. But they also encourage increased hedging by foreigners who own US assets. Japanese investors are among the largest investors in international markets. State Street data suggests they have been increasing their hedge ratio on US assets since March. Moreover, buying currency-hedged US Treasuries had been loss-making and less profitable than just buying Japanese governments bonds – but this has now changed. Lower hedging costs mean that ongoing foreign investment from Japanese institutions is now also more likely to be hedged.

Chart 1: UST 10 yield (JPY hedged) now offering a positive yield

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Source: Bloomberg, Aberdeen Standard Investments, (as of September 2020).

The benefits of opening up

The economic rebound has encouraged investors to move away from safe assets like the US dollar, which they had accumulated in the first quarter of 2020

The US dollar has historically had a counter-cyclical relationship with other currencies. Falling yields have been an important driver of dollar weakness, but the improving macro backdrop has also played a part. Chart 2 shows the historical currency relationship with the macroeconomic environment measured by the global Purchasing Managers’ Index (PMI). Recent US dollar weakness has been consistent with its historical counter-cyclical relationship to the economy. The re-opening of economies along with supportive monetary and fiscal stimulus have spurred an uptick in general economic activity. This has led to improving sentiment in global PMI surveys and a strong recovery in industrial production. The economic rebound has encouraged investors to move away from safe assets like the US dollar, which they had accumulated in the first quarter of 2020.

Chart 2: FX historical betas to the Global PMI

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Source: Bloomberg, Aberdeen Standard Investments, (as of September 2020).

Chart 2: FX historical betas to the Global PMI

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Source: Bloomberg, Aberdeen Standard Investments, (as of September 2020).

Divergent activity profiles across economies may alter these historical relationships. Indeed, the recent recovery has been less synchronised than past cycles. Chart 3 is an example that highlights the impact of relative economic activity on cross-border currency flows. The chart shows the relative US and Eurozone PMI time series, plotted against euro/US dollar. The initial bottoming in Eurozone PMIs versus US PMIs was a supportive factor for euro/US dollar. But that support appears to be fading and should no longer be considered a key driver of further US dollar weakness.

Chart 3: EUR/USD exhibits some relationship to the EZ-US PMI differential changes

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Source: Bloomberg, Aberdeen Standard Investments, (as of September 2020).

Where to now for the greenback?

The drivers of US dollar weakness are diminishing. Real interest rate differentials have stabilised and economic momentum is moderating. We still see greater potential for more US dollar downside than upside. However, this may now require a Covid-19 vaccine to be approved and widely distributed. Or it may require the resolution to some imminent negative catalysts for the global cycle – the lack of fiscal stimulus renewal in the US, rising tensions between the US and China, rising Covid-19 cases as winter approaches in the northern hemisphere, and the US election.

Other major currencies

While the US dollar tends to receive most attention, there have been other notable trends in currency markets. The best performers this quarter have been the Norwegian krone and Australian dollar driven by supportive commodity prices and Chinese infrastructure stimulus. By contrast, some emerging market (EM) commodity currencies, including the Brazilian real, have performed less well because of more significant economic damage and a slower recovery.

Looking ahead, we expect the Japanese yen to benefit in the lower interest rate environment. The yen also helps with portfolio diversification. Our conviction in long euro exposure has faded. This reflects our ongoing concerns about the sustainability of the European recovery and waning euphoria for the Eurozone recovery fund. We expect the British pound will remain hostage to Brexit newsflow, making any strong conviction view on the pound difficult and risky. Our appetite is growing for broader EM currency exposure, however. Concerns about some of the structural fragility in certain EM economies are unlikely to disappear. Nevertheless, some tactical indicators are turning more favourable. In particular, the relative monetary regime has improved, given such low interest rates in developed markets. Also, valuations are attractive and investor positioning is light. Top-down cyclical factors have historically been associated with EM outperformance but this has not been the case this year. As we look forward to 2021, this may change.

The economic rebound has encouraged investors to move away from safe assets like the US dollar, which they had accumulated in the first quarter of 2020
 

Tactical Asset Allocation

MULTI-ASSET

The Multi-Asset Tactical Asset Allocation (TAA) team’s view on bonds, equities, commercial property and other assets will affect 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).

The views of individual asset class teams may differ to this multi-asset TAA view.

ASSET CLASS POSITION COMMENT
Government Bonds Negative

Our underweight position in government bonds has been reduced partly because our credit asset class overweight has been trimmed. However, our interest exposure, as measured by duration, remains largely unchanged and close to neutral (as we have reduced our US Treasury underweight)l: while we think government bonds in the developed world are expensive, the conditions for a substantial rise in yields are still not in place: central banks are expected to maintain a very loose policy stance for a long time, growth risks remain skewed to the downside, and inflation is expected to remiain well contained. Within the government bond asset class we have added a little to our Australian bond position to earn a little more yield and to strengthen our portfolio's hedge against economic disappointment. We have also introduced a US Treasury yield curve steepening view on a belief that the Federal Reserve will be less able to suppress the level of longer-dated yields as economic growth re-accelerates next year (but the more granular nature of this position cannot be reflected in the table). While we still think the market's US inflation expectations can rise further on a 12 month view, we have decided to trim our break-even inflation position, especially given short-term downside risks to growth over the course of the next 3 months. We have also eliminated the underweight position in UK index linked bonds, which was the counterpart to an overweight in UK investment grade corporate bonds, preferring to express a purer yield curve steepening view in the US.

UK Gilts Neutral
US Treasuries Positive
European Core Negative
European Periphery Negative
Japan Negative
Australia Positive
UK Index Linked Neutral
US TIPS Positive
Credit Markets Positive

The attraction of credit has diminished as spreads have narrowed over the last few months and so we have trimmed our overweight by eliminating our investment grade overweight. However, we expect investors' hunt for yield to remain a powerful force, leading to some further spread compression in lower quality credits, namely high yield. As a result, we have reinvested some of the proceeds of our investment grade sales in US and Euro high yield markets, with the reduction in duration from these changes offset by US Treasury purchases. At the same time we have taken another small step to add to our Emerging market local currency bond position. While EM economies face considerable challenges, those which face the biggest issues have already seen material currency weakness and have lagged in the recovery that other credit sub-asset classes have experienced. An improvement in the global economic cycle over the next 12-24 months should gradually improve sentiment towards unloved EM currencies, and so we think it is appropriate to continue averaging into a bigger overweight position. However, we do not wish to increase our overall Emerging market debt exposure at present, so have trimmed our hard currency bond overweight at the same time.

UK Investment Grade Neutral
US Investment Grade Neutral
Euro Investment Grade Neutral
US High Yield Positive
Euro High Yield Positive
Emerging Market (Hard Currency) Positive
Emerging Market (Local Currency) Positive
Equities Positive

We retain a modest overweight stance in equities; while behavioural 'buy' signals have essentially moved to a more neutral stance, we are still far away from our indicators signalling greed and complacency. Sentiment remains depressed, and while institutional asset allocators have moved to express an overweigth stance, it remains less prevalent than usual. At the same time we have witnessed a healthy bout of US IT sector profit-taking. The challenge is to balance short-term downside risk to growth and event risk in the shape of the US election, with the prospect of a renewed acceleration in activity during the course of 2021. We expect a range-bound global equity market over the next month or so, with a Democrat clean sweep election outcome likely to provide modest upside support, a Biden win with a split house likely to do the opposite. However, in anticipation of a healthier 2021 we have decided to initiate an overweigth stance in Japanese equities, funded by taking Pacific ex Japan to underweight, with the latter's significant Financials exposure is expected to remain a drag on performance.

UK Neutral
US Positive
Europe ex. UK Positive
Japan Positive
Pacific Asia ex. Japan Negative
Emerging Market equity Neutral
Property Neutral

A significant portion of the REIT investment universe has been severely disrupted by lockdown and social distancing policies and while long-term value exists in some areas, the outlook remains too uncertain to express an overweight stance. There is a huge divergence of fundamentals depending on the sector (e.g. data centres vs. retail), but at some point confidence in cash flows should improve in some of the challenged sectors. While low interest rates are supportive of REITs outperforming equities, the essential condition for this to trigger is a benign and stable growth outlook, but a catalyst for this to happen remains outside our investment time horizon.

US Neutral
Europe Neutral
Alternatives Positive

In search of alternative sources of diversification, we have used the recent sell-off in gold to introduce a small overweight stance. While we do not expect gold to outperform equities, the asset class should benefit portfolios in the event that governments are forced to fund increased fiscal support through greater debt issuance.

Gold Positive
Cash Negative

With interest rates so low, cash remains the preferred funding source for risk-on positions.

CURRENCY OVERLAY POSITION COMMENT
Dollar Negative

The global compression of interest and bond yield spreads means that monetary factors are a less powerful driver of relative currency performance; nonetheless, the sharp decline in US interest rates relative to other major currencies has not been fully discounted and would support further modest US dollar depreciation. However, given the extent of the currency's depreciation in recent months, we have decided to trim our underweight. At the same time, the strength of the Euro has been significant, and we have shifted from over to underweight, while maintaining our Japanese yen overweight. A re-acceleration of global growth (beyond any short-term pause related to containing Covid-19 using localised lockdown policies) should also, at the margin, benefit pro-cyclical currencies such as in Emerging Markets and we have added a little more to our overweight. We are still using the Australian dollar underweight s a potential cyclical hedge given its strong performance in recent months and have increased the position at the margin.

Euro Negative
Yen Positive
Australian Dollar Negative
Emerging Market currencies Positive
Sterling Neutral

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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.