What our House View means for asset allocation and portfolio construction.
4 minute read
Finding safe harbours
- Market reaction to disappointing growth triggered a shift in stance from the Fed
- As better data ease recession concerns, this prolongation provides a window of opportunity for risk assets, particularly emerging markets
- The success or failure of Chinese stimulus will have significant ramifications for global growth
- Vol of Vol has risen and this makes liquidity concerns even more notable
The change in Fed tone will extend the economic cycle in our view
The most significant change to our house view over the last quarter has been around our expectations for further monetary policy normalisation from the Fed.
While we expect the Fed to remain data-dependent, disappointing growth data and subsequent market reaction means Fed normalisation is now largely complete.
US GDP continues to expand above potential, increasing wage growth and spurring capex spending. Yet inflation remains quiescent. Whereas we spent most of 2018 positioned for rate hikes and inflation, we don’t think that dynamic will repeat; in addition to signalling a long pause in raising rates, the Fed has said it will cease shrinking its balance sheet in September.
On the other hand, the ECB is nowhere near this point, having recently signalled it has no plans to raise rates this year. Meanwhile the BoJ is conducting QE-infinity.
This has resulted in a shift to our duration view: even though we think the Fed may have one hike left in this cycle after the current pause, we currently prefer to have a neutral allocation to bonds. This is because we see a US slowdown continuing beyond 2019, with growth having peaked in mid2018, and Europe and Asia are experiencing a more entrenched deceleration.
At this point in the cycle, with 2-year USD swap rates moving from 0.5 per cent to over 3 per cent before the recent move back to 2.5 per cent, the big move up in rates is over (for now), and US Treasuries have revived their role as an important defensive diversification tool.
The outlook for risk assets is linked to the success of the Chinese stimulus programme
China stimulus and its subsequent success in stabilising Chinese growth at around six per cent remains critical to supporting risk assets more broadly, but is not yet enough to spark global reflation as it did in 2017; we expect trade tensions to ease but some permanent damage to growth has been done, and risks remain.
Emerging markets will benefit from the window of opportunity that has opened as the risk of restrictive monetary policy lessens
With developed market central banks taking a more dovish tone, the risk that restrictive monetary policy impedes growth and pushes economies towards recession is significantly diminished (Figure 1). We believe this creates a window of opportunity in which risk assets can deliver attractive returns. Indeed, risk assets such as emerging market equities and currencies have performed well in Q1 19 for this reason.
Figure 1. Market expectations of FOMC policy (OIS) have repriced dramatically since Q4 2018
For this constructive environment to remain intact, it is important that the growth slowdown in major countries stabilise, particularly in China. Several stimulus measures from China and some tentative positive turns in the data support our view that global growth will remain above potential and extend the cycle.
To take advantage of this period of relative calm, we prefer high yielding emerging markets where there is potential for both rates and currency to outperform, and therefore we increased our allocation to EM credit in both hard and local currency.
While the USD has weakened versus emerging market currencies since the start of the year, the extent that this trend continues will likely depend on whether the slowdown in US growth bottoms. Historically EM currencies offer an attractive return profile verses the US dollar when the American economy is expanding (Figure 2).
Figure 2. EM FX performs well in environments of stronger US growth
Yet the market remains fragile with the volatility spiking
That said, political risks remain high, with many emerging market economies due to have elections in 2019. While volatility will surely be lower as central banks support markets and growth stabilises, changes to the regulatory environment and market structure mean we are likely to see more shocks within what otherwise appears to be a lower volatility environment. With the stability of volatility falling, factors such as liquidity and sensitivity to global “risk-off” moves will remain important when selecting which emerging markets to invest in.
For developed market currencies, growth is key
The extent that growth stabilises and remains above potential will also be important in driving return expectations for developed market currencies.
We maintain our preference to be short the Australian dollar given further downside risks to growth driven by weaker household consumption and the outlook for wages. As markets price in an increased probability of a more dovish Australian central bank, the 2-year rate differential to the US suggests that the Australian currency has room to weaken further (Figure 3).
Figure 3. Rate differentials between the US and Australia support a weaker AUD view
Within equities, valuations look fair and we expect gains to be in line with slower but resilient earnings growth
The Q4 earnings season showed that corporations (particularly in the US) are still able to generate plentiful revenues and profits, even as margins are no longer expanding as they could early in the recovery. In addition, earnings per share (EPS) are growing, albeit at a slower pace than in early 2018 (Figure 4). Debt has risen but interest coverage is ample and will remain so, absent a sharper economic decline.
Figure 4. Earnings are growing, albeit at a slower pace
The rapid fall and subsequent rebound in markets leaves valuations fairly valued in the US, but this remains our preferred region as Europe and much of Asia have weaker fundamentals. Despite our base case of above-trend growth and reduced risk from restrictive monetary policy, there is not much scope for a strong positive bounce in growth or earnings, and low inflation is partly a reflection of a lack of pricing power (Figure 5).
Figure 5. Global Equities price a bottoming in global growth slowdown
We therefore remain moderately positive on equities, expecting gains in line with this slower, but resilient, earnings growth, helped by dividends and buybacks.
The divergence between US growth and the rest of the world, with emerging markets underperforming, was one of the main drivers of EM equity and currency underperformance. However, that gap began to close late in the year as the US “caught down”, and we expect EM to perform positively going forward. In Europe forward multiples are lower than in Japan and the US but risks are higher, growth is lower, and catalysts to change that are missing. Japan has more upside potential, with a calendar stacked with stimulus from royal and sporting events, and firms that stand to benefit from a rebound in global trade.
Credit has performed well year-to-date and we expect further value to be unlocked in the current period of stability
Credit spreads have performed very well so far this year in both Europe and the US, recovering most of the widening of Q4 2018 across both investment grade (IG) and high yield (HY). However, the levels remain above their average of the past two years.
As with other asset classes, the current environment seems supportive to unlock some of that value and deliver positive carry and rolldown even in a stable situation. The main risk is credit deterioration, with leverage very high, driven by capex, M&A, and shareholder-friendly buybacks; this is reflected in lower interest-coverage ratios even with overall yields still quite low.
However, the downdraft in inflation and economic growth has not been too severe, even though it has been enough to put central banks on the sidelines: this is being reflected in rates and FX volatility being subdued. This usually pushes credit spreads lower too, and we have upgraded our views on the asset class; we expect BBB-rated companies to utilize this window of calm to shore up their finances, but our constructive view is contingent on recession risk remaining low in the US and euro zone.
Utilities and Retail have well-telegraphed debt and revenue problems, but elsewhere EBITDA remains healthy (+9.2 per cent y/y; +4.3 per cent y/y excluding commodities, according to JPMorgan) and profit margins stellar (Figure 6). These healthy fundamentals are unlikely to remain intact in a severe downturn and we expect them to be adversely impacted if Chinese growth fails to stabilize. The build-up of debt in the non-financial corporate sector is, of course, itself a contributor to two of our risk scenarios: debt-service strains and bouts of compromised liquidity.