What our House View means for asset allocation and portfolio construction.
5 minute read
Positioning for a further slowdown
- Equity and corporate credit: EM duration to beat equities
- Developed FX – growth, policy and liquidity prop up USD
- Government bonds – positive US, Australia, and EM Local
Late-cycle, not (yet) end-cycle
The market implications of our House View lead us to position portfolios conservatively, retaining a preference for duration (particularly in the US, Australia, and Canada) and the US dollar.
Slowing growth, trade conflict, and policy responses drive our asset allocation
We maintain a neutral view on equities, preferring exposure to credit and emerging market bonds. This is because global growth, having peaked in Q4 2017, continues to slow, although in the past few months the pace of deterioration has decreased.
High-frequency signals (e.g. the ratio of copper to gold, orders-to-inventories, and OECD Composite Leading Indicators, shown in Figure 1) suggest no let up in the broader trend. While trade talks have resumed, risks of renewed US-China tension remain high; other conflicts, such as the Japan-Korea spat and clashes between the US and EU, also bear watching.
Figure 1. Copper/gold ratio and global growth
The outlook for world trade is negative, as shown by the recent European PMIs and Korean exports. The silver lining for asset markets is a global easing cycle, with central banks across developed and emerging markets slashing rates and supporting our constructive view on bonds.
In the US, apart from the weakness in manufacturing, there has been sequential moderation in non-manufacturing growth. Moreover, national accounts data revisions were substantial, showing corporate profits from the National Income and Product Accounts recording zero growth since 2014. This means equity and credit markets are vulnerable to a drop in corporate earnings and other shocks, despite these markets’ resilience to the downgrades throughout 2019.
Equity and corporate credit: Selection in a declining environment
The weakness in overall earnings growth (Figure 2) and the outright negative earnings in EM keeps us neutral on global equities: valuations are “cheap” for good reason, and expectations for double-digit growth in 2020 across almost all regions are challenging, and likely to be downgraded.
Figure 2. Weak ISM associated with falling earnings
US equities to outperform EM; credit can perform well despite stagnating EPS
We are overweight the US over EM, given that the outperformance of US corporates’ EPS has been a good barometer for EM underperformance (Figure 3); Japan’s vulnerability to China and its own weak internal growth justifies an underweight there.
Figure 3. EM equities outperformance follows relative earnings
Given that our House View is that a global recession is neither imminent nor inevitable, we prefer to take exposure to some risky assets via corporate credit, with slight exposure to US and Euro Investment Grade and High Yield.
Emerging market spreads and duration are also attractive
We have upgraded euro credit due to ECB policy that is supportive of spreads (including direct purchases through the APP), and we think bank CoCo/AT1s offer good fundamentals and a spread pickup to non-financials. However, we’ve downgraded US HY a notch – solely on the back of strong performance year-to-date. We expect a low default rate to continue, but spreads have come in from a peak of 537bps in January to around 370bps.
In contrast to our wariness on emerging market equities and cautiousness on currency (see below), we have a strong preference for external credit and local duration: EMBIG spreads of 350bps are similar to HY for a “split-rated” asset class, and still far from the overvalued sub-300 spreads reached in 2013, 2014, and early-2018.
Moreover, the adjustment to current accounts and weaker currencies has enabled many central banks to reverse their 2018 hikes: many are in the middle of extended easing cycles that have not yet ended, and can lead to continued bullish steepening. Duration plays we favour include China, Indonesia, and Mexico.
Global equity markets ended Q3 with a large “factor reversal”: sizeable equity positions had been accumulated over many years in factor-driven themes such as value versus growth, cyclical versus defensive, low versus high momentum and to a lesser extent smaller versus larger market capitalisation stocks.
After generating steady positive returns for long periods, these tilts had become stalwarts of many quant and hedge funds. Growth stocks have consistently outperformed value stocks since before the GFC – the longest such period since the 1970s.
The resulting reversal has been quite violent in some areas of the equity market, with the “one year price momentum” factor exhibiting its two largest negative daily returns since 1984 at the start of September and many other factors recording multiple daily standard deviation moves. The proximate cause seems to have been a slight brightening of the global economic outlook and the sharp rise in yields that followed, after the strong rally in global bonds year-to-date.
Continued reversal of many of these themes will likely require further support from higher rates backed by more robust economic growth, which is not consistent with our current House View. Whether in bonds or equities, we will take note of heavy positioning in “consensus” views.
Developed FX – growth, policy and liquidity issues prop up the US dollar
The multiple global risks have continued to have an outsized impact on non-US economies.
Recently, domestic US data (housing market, non-manufacturing activity indicators) have surprised to the upside, with few signs of stabilisation in much of the rest of the world.
This is the core reason why our outlook for the US dollar remains bullish – periods of weak global trade growth have historically come alongside a strong US dollar, and so far this episode has been no different (Figure 4).
Figure 4. US and world trade volumes
From a policy perspective, the relative monetary-policy outlook (the Fed versus the rest) is USD supportive, even as high US rates have more room to decrease. The ECB has embarked on another round of QE to accompany a rate cut, while the PBoC has cautiously eased policy via RRR cuts. If the extent of policy easing priced into USD money markets proves excessive, this would push the dollar higher.
Thirdly, the recent funding-market stresses, if not contained effectively, could also spur dollar appreciation. Despite the two rate cuts by the Fed, the erosion of the dollar’s yield advantage has not been large, especially in volatility-adjusted terms.
Among G10 majors, the euro is likely to depreciate once a post-ECB positioning clear-out is behind us. Apart from policy divergence, European data is showing limited signs of the slowdown bottoming. Risk of a recession in Germany remains high as manufacturing slumps.
USD and JPY should outperform trade-sensitive EUR and “commodity” currencies
The yen, on the other hand, will likely be a regional and global outperformer as sentiment deteriorates into year-end and due to escalating geopolitical issues such as Saudi-Iran tensions and Brexit. By the same token, the Australian dollar, Asian currencies such as the Korean won, and trade-sensitive EM currencies are likely to be underperformers.
Government bonds – mini tantrum episodes unlikely to change outlook
Government bonds remain a bulwark, “mini-tantrums” notwithstanding
The challenging global growth backdrop means that any “mini-tantrum” sell-off in government bonds will be ephemeral. The decline in long-end yields since the end of July resulted in excessive positioning, but the subsequent retracement proved short-lived.
In recent years, it has often been seen that when anticipation of a QE announcement is high, bonds tend to rally aggressively in the lead-up to the QE (the “rumour”) but sell off briefly after the “fact” of the programme.
While fiscal support for economies is an important theme of our House View, it is moderating a slowdown rather than sparking a renewed reflationary expansion as in 2017-18, and so fiscal pressure on bond yields or term premia is minor – though in many cases we observe swaps are outperforming cash bonds.
Indeed, bonds yields of major government bond markets have been pinned down by low growth, and indicators such as the global manufacturing PMI continue to show signs of contraction (Figure 5). Forward-looking indicators of the global industrial cycle, such as China’s credit programmes, do not point to an imminent recovery in manufacturing PMIs.
Figure 5. US Treasury yields and global manufacturing PMI
There have been recent worries about a spike in US inflation, with core inflation rising to the highest level since 2007 in year-on-year terms. However, core inflation has historically tended to track the path of growth with a lag of 18 months to two years. With growth moderating, it is unlikely that core inflation will surprise to the upside for too long. All in all, it remains a supportive environment for bonds, despite their low yields.