What our House View means for asset allocation and portfolio construction.
5 minute read
Positioning for a further slowdown
- Disappointing growth and increased risks lead us to downgrade risky assets
- Government bonds are less attractive but are valid assets for hedging purposes
- Risk-reward favours credit over equities
- Stay long US assets
Having started the year with a decisively risk-on view in equities, we have now scaled back our preference for the asset class, taking our overall allocation closer to a neutral position.
This change should be seen in the context of the strong performance in global equity markets so far this year, and at a time when a recovery in economic growth remains elusive but would be needed to support a fundamentally driven move higher in risky assets.
At the same time, the downside risk from a trade dispute escalation between the US and China delaying the growth recovery further have risen and are, in our view, not fully appreciated by markets.
As a result, we have downgraded our view on equities. Combined with a modest preference for duration, the portfolio now reflects what we regard as more acute downside economic and market risks.
Among risky assets, we prefer credit, specifically high yield and emerging market hard currency, over equities.
Growth outlook has deteriorated; Central Banks are quick to react
The US remains our preferred equity market, balanced by an underweight position in EM. Slowing growth and rising risks have prompted central banks to respond, with nearly all giving clearly dovish forward guidance or commencing rate cuts.
Global bond markets have reacted accordingly and, in the case of the United States, are priced for a reversal of the 2018 rate hikes. With the speed and magnitude of central bank support having become clearer in recent weeks, any easing of economic tensions between the US and China or signs of a global growth stabilisation would lead us to re-consider our asset allocation stance and favour a more positive risk allocation.
The year-to-date rally in equities is to be seen in the context of oversold levels in Q4 2018. Markets at that time de-coupled from economic fundamentals, not least due to an intensifying standoff between the US and China in trade matters and fears of tighter monetary conditions.
Amid continued positive earnings growth during that sell-off period, valuations adjusted to reflect significant discounts. When the Fed offered support by refraining from further policy rate increases, the tone between the US and China eased and the feared US earnings recession in the first half of 2019 was averted, markets rallied back towards long-term average multiples.
In our view, the probability-weighted outlook for equity risk has turned less favourable. This is because global equities have returned to close to their record highs at a time when earnings growth is meagre, and when the multiple is already reflecting a discount rate that incorporates a cumulative 100bps expected rate cut in the US by end-2020 (Figure 1).
Figure 1. Market expectations for policy rates have shifted dramatically
FOMC policy expectations (OIS)
We think the trade standoff between the US and China will prove to be a deeper-rooted conflict, and that economic growth is continuing to slow into H2. Incorporating our global growth outlook into our assessment for the asset class, it is notable that historically, periods during which global growth fell below 3 per cent in year-on-year terms were associated with negative earnings growth 80 per cent of the time (since the late 1990s: Figure 2).
Figure 2. Sub 3 per cent global growth rates have historically coincided with negative earnings growth
Our central expectation for global growth is for a stabilisation at, or just below, 3 per cent. As we don’t anticipate a deterioration in growth beyond these levels, and therefore see the global economy escaping recession, a prolonged period of negative earnings growth might be circumvented.
However, given the comparably high expectations built in for earnings growth in 2020 (Figure 3), we do envision chances for disappointment relative to actual earnings delivery to be meaningful.
Figure 3. High expectations for earnings growth in 2020
Consensus expected EPS growth for 2020 in per cent
China’s efforts to stabilise growth remain critical for commodities and the global economy. Beijing’s credit tightening of 2018 has been reversed, income tax cuts are supporting retail sales, and PMIs rebounded in Q1 before easing back a bit in Q2. However, with the US/China trade conflict persisting and broadening to other countries, confidence has again been rattled and industry is still slowing (Figure 4).
Figure 4. Chinese growth indicators are stabilising, but remain fragile
Regional tilt: long US vs Emerging Market equities
Having realised the benefits of better liquidity conditions in the G10, and with less spillover outside China compared with past infrastructure and property booms, we have shifted to an underweight view on EM equities. The underweight is offset by an overweight view on US equities, with US earnings expected to continue to outperform EM. A positive earnings growth differential in favour of the US has historically most often led to positive performance of such trade (Figure 5).
Figure 5. Positive US over EM earnings growth usually coincides with relative US outperformance
Another reason to remain cautious on EM equities is our outlook for EM currencies (against the US dollar). We have preferred a short basket of low-beta Asian currencies to hedge against a downturn in global growth and/or an escalation of the trade dispute for more than a year now.
For developed currencies, a tug-of-war between growth, valuation and rate drivers
This underweight view in EM currencies is against a long USD position, which we think is not only attractive in terms of carry but also because it stands out as a beneficiary of slowing global growth and growth divergence (Figure 6). Moreover, periods of illiquidity in USD funding markets as well as the periodic spikes in risk aversion are likely to contribute to USD strength, along with other “safe havens” such as JPY and CHF.
Figure 6. USD benefits from growth differentials
Conversely, we maintain our preference to be short euros and the Australian dollar. Both should underperform in a global growth environment that continues to weaken and where trade disputes remain an ongoing theme.
While in theory, the Fed can cut more than the ECB or RBA, we are wary to adopt the recent market narrative that this will drive sustainable dollar weakness. This is for two reasons: (i) aggressive Fed cuts are already priced into the curve, and (ii) the current economic situation in the US doesn’t call for as strong a policy response as in the euro zone and Australia.
Government bonds remain supported, despite low yields
Across developed markets, risk-free 10-year bond yields have dropped between low double-digit figures (Japan) and up to 100 bps (Australia) year-to-date. In Q1, when recession fears faded, risk assets outperformed bonds, but with the global manufacturing PMI dipping below 50 in recent months, bond yields have fallen dramatically again: the global treasury benchmark’s average yield dropped from 1.17 per cent to under 1 per cent following Mario Draghi’s speech at Sintra in June.
Despite lower coupons and paltry rolldown, risk-free assets remain an important diversifier. While shorter-dated bonds are useful for funding, especially in Japan and Europe, moving further out on the maturity and credit spectrum is appealing; this is not a mere reach for yield, but is supported by business cycle dynamics and relative pricing.
Corporate and EM credit have repriced more than equities
While US equities are near all-time highs, and European stocks are only a couple of percent lower than 2018 highs, spreads on corporate bonds and hard-currency EM sovereign debt are now far more attractive than the extremely tight levels of early/mid-2018.
In particular, European and US HY spreads around 100bps above their 2018 tights, offer compelling carry and rolldown, with a still sparse default rate. We don’t expect to revisit recent lows in spreads as fundamental credit metrics have deteriorated, but a grind lower is likely as monetary and fiscal stimulus gets us through the soft patch.
We find EM sovereign dollar spreads appealing overall too, with a spread of around 370bps and steep credit curves offering good compensation for a “split-rated” asset class that compares well with triple-B corporates at approximately 150bps and double-Bs at 250bps over US Treasuries.
Though our asset allocation overall is conservative, we should note that there are still important risks to consider.
Should the Fed not deliver on rate cuts that it signalled are likely in the June FOMC meeting, global yields could reprice meaningfully, even in the absence of hikes. Moreover, if a lasting trade détente is reached with China, and EU auto tariffs and “No Deal” Brexit are avoided, we could see pent-up demand and investment accelerate, lifting inflation and growth, with yields and risk assets in their wake.
A relatively defensive portfolio would then suffer a mix of opportunity cost (from being close to neutral overall) and some losses (EM underweight and duration), even as US equities and global HY and EM would make gains. On the downside, should growth deteriorate, and trade wars become damaging and disruptive, long duration positions may only partially protect losses in credit markets and global equities.