Multi-asset allocation views: Why now is not the time to give up on US Treasuries

There is still a good case for US Treasuries and long duration in multi-asset portfolios, argues Sunil Krishnan.

4 minute read

In recent weeks, the economic and geopolitical backdrop have led us to maintain a wary stance. While a recession is not our central scenario, we want to factor in the risk of a further slowdown.

While the US and China seem at last willing to stop their trade relations from deteriorating further, the medium-term forces behind the tensions are stronger than the question of how much American soy China is willing to import. We have entered an era of strategic competition between China and the US covering a broader range of issues – from intellectual property theft to the security of 5G technology. This has raised concerns across the US administration and security services, with bipartisan support. There is no appetite to include these issues in the current negotiations, and they are unlikely to be swiftly resolved.  

Companies and countries may be forced to choose sides, affecting the infrastructure of global trade

This will have economic consequences in the coming years. At times, companies and countries may be forced to choose sides, affecting the infrastructure of global trade. It also raises questions for the US financial ecosystem. Will US businesses have to reconsider their investments? Will Chinese firms find it harder to list on US exchanges? 

A second point strengthens the case for caution. The global economic outlook is worsening, and there could be a spill over from weaker to more resilient areas of the economy.  We have identified several key factors to watch.

Manufacturing is volatile and a recession in the US may not turn into a global one

Long-term manufacturing data has clearly pointed to a recession for most of 2019 but, as economists know, manufacturing is volatile, and a recession there may not turn into a global one. Historically, the ballast of developed economies has been consumer spending and the services industry; services make up three quarters of the US economy, while manufacturing represents less than 15 per cent. 

Figure 1: Global growth outlook (y/y)

Global growth outlook (y/y)
Source: Aviva Investors, Macrobond, as at 27 September 2019

Figure 2: Global manufacturing and trade

Global manufacturing and trade
Source: Aviva Investors, Macrobond, as at 27 September 2019

Signs of weakness in consumer spending and services

Manufacturing weakness has fed into expectations for corporate profits, with analysts now expecting earnings to be lower than a year ago after several rounds of downgrades. Overall earnings growth for 2019 is expected to reach 1.5 per cent, which may provide some scope for selected positive surprises, although national accounting measures of profits have recently been revised down to show a lower path for profits over the last several years. Europe, Japan and emerging markets have posted lower profit growth for longer than the US. The risk is that further weakening may eventually impact consumer demand, in turn hitting companies’ ability to fund dividend payments and share repurchase programmes.

Figure 3: Weak ISM Manufacturing associated with falling earnings

Weak ISM Manufacturing associated with falling earnings
Source: Macrobond, Refinitiv Datastream, as at 27 September 2019
Services confidence indices are weaker in Europe where a loss of momentum is evident

We are not yet seeing a turn for the better. Services confidence indices are weaker in Europe, where a loss of momentum is evident, and in the US, where the Institute for Supply Management’s Non-Manufacturing New Orders index has fallen by over ten points since February – though it remains above contractionary levels.

Figure 4: MSCI Earnings estimate (1y fw) versus Citi Global Eco Surprises

MSCI Earnings estimate (1y fw) versus Citi Global Eco Surprises
Source: Macrobond, Aviva Investors, as at 29 October 2019
Demand for corporate loans is down and surveys from regional Fed banks show capital expenditure slowing down

Capital spending plans are an important outlook indicator. According to US banks, demand for corporate loans is down, and surveys from regional Federal Reserve (Fed) banks show capital expenditure slowing down. These issues are garnering more attention, with OECD and IMF forecasts for global growth also revised down recently. We currently see a one-in-three chance of a recession: this doesn’t mean we expect one, but it needs to be factored into our investment decisions.

Figure 5: Investment growth has slipped

Investment growth has slipped
Source: Aviva Investors, Macrobond, as at 27 September 2019

Protecting portfolios through duration

In this context, we favour government bonds: we are long duration versus benchmarks, particularly on US Treasuries. They remain the most effective hedges of market risk, and the yield on 30-year Treasuries is still attractive, even for portfolios with higher currency-hedging costs. Central banks are committed to a period of easy policy, and inflation should remain contained, even if the economy stabilises – limiting the downside to Treasuries if recession is averted.

In addition, we have a neutral stance on equities – the current backdrop poses risks to corporate fundamentals – but we continue to see opportunities in higher-yielding parts of the bond markets, including hard-currency and local-currency emerging market debt and global high yield.

Spotlight on US financials

Our portfolio positioning is not solely driven by seeking safe havens, however. We also like growth assets where valuations offer a margin of safety, which is the case with US financials.

Analysts see two major headwinds to US financials’ performance against the broader market in the next 12 to 18 months

Analysts see two major headwinds to US financials’ performance against the broader market in the next 12 to 18 months, particularly banks. The first is that margins on lending are compressing because the Fed raised short-term rates but bonds with longer maturities have seen yields decline. Banks are limited in their ability to reduce deposit rates, while getting paid a lower yield on their own longer-term loans.

Secondly, loan growth has not been spectacular this year, falling from an annualised rate of six or seven per cent per annum at the end of 2018 to three to four per cent more recently.  As a result, analysts have reduced their profit forecasts, with many expecting outright declines in the income earned from deposits and lending (net interest income).

Share price performance, and company results, have become increasingly resilient to declines in bond yields

Nevertheless, we continue to see opportunities in the sector. When the Fed last cut rates, analysts priced in a series of further cuts, blunting the sensitivity of financials’ performance to future policy measures. Even as interest margins fall, volume growth should be enough for banks to post growth in net interest income. This has played out so far. Share price performance, and company results, have become increasingly resilient to declines in bond yields. 

Credit losses could also hit banks in a recessionary scenario, but credit affordability remains decent, supported by refinancing of mortgages and low unemployment. We continue to watch this area closely, but at this stage credit quality is proving resilient.

There is a valuation gap between financials and the rest of the US market due to high tech-company valuations and weak performance by financial stocks

Looking at key metrics, like price-to-earnings or price-to-book ratios, there is a valuation gap between financials and the rest of the US market. This is due to high tech-company valuations and weak performance by financial stocks, while the combination of financials’ dividend yields and share buybacks means the sector is distributing a high level of returns to investors. This combination is attractive.

Figure 6: US financials: relative valuation vs US market

US financials: relative valuation vs US market
Source: Refinitiv, Aviva Investors, as at 1 October 2019
US financials also offer reasonable transparency and balance-sheet solidity – leaving them as a high-quality play on the style

US financials could offer the potential for strong returns if the domestic economy stabilises, with a margin of safety should growth slow further. They are also a value play, and the recent rotation of the market out of growth stocks and into value has benefitted the sector. Compared to other value stocks, US financials also offer reasonable transparency and balance-sheet solidity – leaving them as a high-quality play on the style.

This article originally appeared in Investment Week.

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