What our House View means for asset allocation and portfolio construction.
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- Improving growth momentum and earnings lead us to prefer an overweight position in global equities
- We prefer to be broadly neutral on government bonds as central banks are likely on hold and term premia compressed
- We prefer to be slightly overweight credit, but a preference for emerging market debt
2019 turned out to be a soft landing year from an economic growth perspective. This was largely thanks to the Federal Reserve’s pivot in December 2018, its subsequent cumulative 75bps easing in the policy rate and central banks globally following with easier monetary policy.
Global economic growth continued to slow throughout the year. However, ahead-of-the-curve monetary easing led, not only to lower discount rate allowing for valuations to increase, but also mitigated the steepness of the growth slowdown and re-directed investors to focus on the subsequent stabilisation and inflection of economic growth. Such mid-cycle inflection points have historically posed a very supportive backdrop for risky assets, leading to median MSCI AC World returns of approximately 15 per cent in the subsequent 12 months (Figure 1).
Figure 1. Distribution of returns in past mid-cycle recoveries
The prospect of no further slowing in economic growth, together with a temporary de-escalation in the trade war between the US and China, allows market participants to price out what had been higher chances for a global recession than in any given year. Probability-weighted outcomes between a central and the downside scenario have shifted upwards, leading us to start the new year with a decisive pro-risk allocation.
Expect 2020 returns to be driven more evenly by valuations and earnings growth
While 2019 was a year of valuation expansion (Figure 2), 2020 is likely going to be a year of returns more evenly driven by fundamentals and expectations.
Figure 2. Valuation expansion to drive equity returns rather than earnings growth
Overweight equities as global growth stabilizes, and recession fears abate
For equities, that means we expect annual earnings growth, which had been roughly flat in year-on-year terms in 2019, to return into positive territory. As valuation proves to be a credible anchor for equity returns only over a very long time period, a further expansion amid lessening global risks and the expectation of a pick up in growth materialising, could lead to additional multiple expansion in 2020; that is despite the current 12m trailing P/E of global equities already trading beyond their 10-year average.
Over shorter-term horizons, we regard the strength of trend-following in markets themselves as a useful indicator for future prices – whereby the development of a meaningful trend is considered worth following, even if a rally/sell-off might have taken current valuations above/below historical averages. In this context, we view the current momentum in equity markets, as well as in the underlying macroeconomic data as strong enough to retain our overweight in equities.
Our tilt towards an increased pro-risk stance comes both from a larger allocation to equities and a reduction in our duration exposure.
The risk/return trade-off in being overweight government bonds has deteriorated
The move in developed market bond yields has been broad-based and significant since the beginning of 2019, making the risk-return trade-off of holding the asset class less attractive.
While rates have risen somewhat in Q4, most remain well below their end 2018 levels.
Yields pinned by central banks beings on hold
In G10, only Norway and Sweden have seen front-end rates rise versus the start of the year. However, at the 10yr point rates across all major regions have fallen and remain near the bottom of their long-term ranges. (Figure 3).
Figure 3. Current 10-year rates vs historic range
With rates near historic lows, monetary policy in many G10 economies approaching the lower bound, and the worst of the economic slowdown behind us, the ability to see a comparable rally in 2020 is limited. That said, with many of the major central banks maintaining a more dovish bias and the growth pickup remaining moderate, rates are unlikely to move significantly higher either.
With front-end rates pinned by monetary policy, the long end of the curve offers more protection, if downside risks were to materialize. Across regions, longer-dated bonds in the US offer the most scope for compression. This is particularly stark versus the German 30yr, where the spread to the US 30yr is near all-time highs (Figure 4).
Figure 4. Yield differential between US and German 30y government bonds
Portfolio protection remains essential in a world where the risks continue to be tilted to the downside
Although probability-weighted risks to the outlook have shifted upwards, overall risks to the global economy remain to the downside. With this in mind, many investors will question to what extent duration positions can continue to be an effective risk hedge in 2020.
Looking at the rolling correlation between global equities and US 10yr rates versus the US manufacturing ISM, there does appear to be a cyclical relationship in the effectiveness of duration as a hedge to equities (Figure 5). This cyclical relationship suggests that, were we to see a further drawdown in global growth, the positive correlation between US 10yr rates and global equities should strengthen.
Figure 5. US ISM index and correlation between MSCI world index and US 10-year
To balance protection to downside risks against our more favourable base case for the global economy we favour real rates over nominal. Particularly in the US, market pricing of inflation expectations look low in our opinion.
Taking these changes among asset classes on a headline level together, we are starting 2020 with a risk-on allocation, that is tilted towards equities rather than credit.
That said, we are shy of running the same level of risk we did throughout the early stages of 2019 for two main reasons: valuations reflect part of our envisioned inflection in global growth and secondly, we view the trade conflict among the US and China as unresolved despite the “Phase 1” deal and as being prone to setbacks.
Furthermore, we are well aware of the risks associated with the US presidential election towards the end of 2020 which, depending on the Democratic frontrunner and the final make-up of House and Senate, could pose a challenge for US equities in particular – largely owed to a threatened roll-back of the 2017 corporate tax cuts, increased tech and banking regulations, the potential for buyback taxation, an overhaul of the US health care system to name a few.
Bottoming global growth leads us to prefer more cyclical/value-oriented equity regions
In terms of regional equity allocation, we favour Japanese equities, based on the premise that Japanese earnings growth, which comes off a very low base, is likely to refrain from falling further behind global EPS.
Mitigating global recession fears, the closer we come to an inflection in growth and potential ceasefire in the US-China trade war, may further lead to a rotation out of bond proxies and to a re-coupling of Japanese equities to current USDJPY levels (Figure 6). Furthermore, Japanese equities enjoy a substantial discount relative to US equities, which should provide upside if positive catalysts materialise.
Figure 6. Relationship between USDJPY and Japanese equities relative
In government bonds, we prefer the US over Germany and also favour Italy over German on the basis of the recent convergence trade to continue and Italian political risks to remain tame for now.
We have a neutral view on credit in developed markets given substantial spread tightening. However, we remain overweight credits in emerging markets, particularly in local currency space, where we regard real yields as comparably attractive and see value in the FX component of the asset class.
High-yielding emerging market currencies are expected to outperform low yielders as the moderate pickup in global growth justifies current levels and allows currencies to remain stable and earn carry. Given local currency and particularly high-yielding currencies are more sensitive to the global growth outlook any upside surprises in the growth outlook will be well captured by this asset class.
We are relatively neutral on the US dollar overall, but have a modest overweight position in the Japanese yen given the recent fiscal package announced there and the natural protection provided in risk-off episodes. We are underweight the euro, given it continues to provide attractive carry returns, with low volatility and re-newed asset purchases by the European Central Bank.
Finally, we also have a small underweight in the Australian dollar given likely further easing by the Reserve Bank of Australia in 2020.
Figure 7. Asset allocation
