Reaching a point of no return
Slowing global growth and rising downside risk means reliability of return will be key.
When Federal Reserve chairman Jay Powell warns that the next move in US interest rates is as likely to be down as up, it underscores how sensitive monetary policy has become to the weakening global growth cycle.
The rapid change of tone in Fed communication – just weeks beforehand Powell had signposted multiple rate hikes – was remarkable. But the Fed is not alone.
Confronted by a growth slowdown, central banks in developed markets have put policy tightening on ice. The European Central Bank has pushed its guidance on rate hikes back to 2020. Meanwhile, the Bank of England is on hold amid Brexit uncertainty, the Bank of Japan’s framework for yield-curve control is on lockdown and the Bank of Canada has moved in a dovish direction.
Although China is adding targeted fiscal and monetary stimuli, that’s in the context of an economy transitioning to slower growth. Even then, authorities express a continuing desire to keep a lid on lending in an effort to constrain shadow banking growth.
But we don’t see this broad shift to easier financial conditions as a precursor to a fresh growth cycle. Developed markets are suffering from weakening demographics and heavy debt burdens, after all. Stocks appear overpriced relative to company earnings prospects, while developed market bond yields remain pitifully low.
Storm clouds lurk on the horizon, too, from the fading impact of US fiscal stimulus and the uneasy US-China trade truce to Brexit and political fragmentation in Europe. Geopolitical instability, trade protectionism and populist politics can further disrupt markets in 2019 and beyond.
We foresee considerable potential for financial market weakness. It’s why we think investors should look to moderate their risk exposures. It is a good time to look beyond just equities and bonds – whose return potential has fallen and become more closely correlated.
Diversification is a way to moderate risks without necessarily sacrificing returns. The value of multi-asset investing is being able to combine asset classes with compelling yield prospects but different return drivers. This can smooth returns and reduce downside risk. It is reliability of return that will be key in coming years in the face of jittery markets.
Navigating the downside
Among larger, more liquid asset classes, the relatively high nominal and real yields of local currency emerging market bonds offer appeal. Currency valuations are inexpensive and fundamentals sound, given the healthy medium-term growth prospects of emerging economies. It makes for a compelling risk-return profile.
Emerging market bonds are able to perform independently of equities, as they did during the stock market falls of 2008 and 2018. They provide better downside risk than investors realise – with a historic volatility of 7.3% versus 12.9% for equities.
We choose not to hedge currency risk due to the impact it would have on returns. But we don’t think emerging market currencies are overvalued. We express currency risk relative to a basket of economically-sensitive developed market currencies to dampen the risks.
Separately, we are drawn to listed alternative assets with limited correlation to the economic cycle. What drives their revenues is different to what drives traditional equities and bonds. It enables them to provide recurring income irrespective of broader market turbulence.
Infrastructure assets, for example, have a record of delivering stable, long-term returns. We see good prospects in areas such as renewable energy due to growing demand for clean energy and the prevalence of government subsidies. We invest in operational solar and wind farms with little or no construction risk or economic sensitivity.
We view social housing projects in a similar vein. Projects with long-dated, government-sourced revenues can provide reliable, inflation-linked returns. They have low correlation to more economically sensitive residential and commercial property sectors.
Regulated infrastructure public-private partnerships and greenfield projects also provide essential services and deliver stable cash flows.
In addition, there are a range of investment opportunities in niche areas such as litigation finance, healthcare royalties and asset-backed securities, which offer strong return potential and diversification benefits.
Some companies provide third-party financing to bring commercial litigation cases to court. They earn a percentage of awards to successful claimants, but bear the cost of failed cases – so they’re incentivised to fund lawsuits with the best chance of winning. Their prospects are not tied to economic conditions and they have low correlation to other asset classes.
Separately we have exposure to a fund providing debt financing to biotechnology firms that are backed by royalty streams for drugs and medicine. The risks in this segment are different to risks elsewhere in the portfolio.
At the same time, we are attracted to parts of the asset-backed securities market such as collateralised loan obligations, which offer excess returns over corporate bonds for a similar level of credit risk. We invest through a selection of specialist managers.
Of course, identifying which assets provide good long-term potential at acceptable levels of risk takes experience, good judgment and extensive resources. We research the risk and return drivers across asset classes and distil them into 3-10 year return forecasts.
This helps us to select the best investments, whether they are internal or external, traditional or alternative. Flexibility and diversification will be key as investors attempt to navigate a period of slowing global growth and political instability.
RISK WARNINGThe 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.
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
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