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The central case for the House View remains one of global economic expansion, albeit a less synchronised one than in 2017. Reflation is leading to less monetary accommodation in developed markets, with the Federal Reserve (Fed) leading the way. As the rate hikes we expect are not priced in, a higher, flatter yield curve and stronger dollar are trends that should continue. This is a positive business environment, but trade tensions and political events add considerable headwinds especially across Asia, Europe, and Emerging Markets.
With capital preservation in mind, we have further reduced our overall risk view for the coming months. We view this move as a temporary one given above-trend global growth and our expectation of US and Rest-of-World (RoW) economic divergence to stabilise. However, political uncertainty emanating primarily from the US in the form of various types of economic confrontation has led us to take a more cautious stance and favour more risk-reducing strategies (such as being long US dollars against Asian currencies) more so than during times in which fundamentals can play out in an uninterrupted fashion.
Double-digit global earnings growth and a broad-based de-rating of equity multiples year-to-date (Figure 1) against a solid economic backdrop (Figure 2) set the stage for positive equity market returns ahead, in our view. Our bias is thus to add to market risk if tensions around trade conflicts ease.
US asset outperformance has been one of the dominant topics in markets this year. We view the reasons for this theme as embedded in US economic outperformance, steadily lower opportunity costs when investing in the US, and capital being allocated to the party exhibiting the stronger hand in economic conflicts of all kinds.
In equities space, the US has delivered low double-digit total returns year-to-date, thereby outperforming the Eurozone and Japan which are both marginally up since beginning of year. Emerging markets (EM), the main underperformer this year, have seen severe drawdowns driven to a large extent by US dollar strength. Likewise, the trade weighted USD appreciated by roughly 5 per cent and US High Yield (HY) outperformed other credit sectors.
The slowing of global economic growth momentum coupled with divergence across regions, whereby the US acceleration outpaces the rest of the world, is less supportive for more cyclical regions but more supportive for well-diversified and domestically oriented counties, such as the US. We expect this environment to continue, albeit at lower intensity. Further, a shrinking yield differential between the US and EM (figure 3) has made the risk-return trade off in the US more attractive and reversed some of last year’s carry-seeking trades. Our expectation for the US to lead the way in terms of monetary policy normalization remains in place and we view the market pricing for the Federal Reserve’s interest rate path as underestimating the pace at which we see the Fed hiking rates. Figure 4 shows that the market currently expects approximately 2 hikes of 25bps until the end of 2019; we expect 4 hikes. Any re-pricing on behalf of the market towards higher rates should be supportive of higher US yields more generally and the US dollar. Lastly, trade tensions have long been a risk to and a theme of our House View and are expected to remain periodically a dominant feature.
Taken together, we expect the stronger dollar regime to remain in place for now and are only very selectively exposed in EM asset classes as they remain most vulnerable to tighter global liquidity. At the same time, given our view on the Fed and a benign global economic outlook, we continue to favour short duration positions across regions.
Emerging Markets have, across asset classes, seen a violent sell-off year-to-date, which can only partly be blamed on trade tensions. The cases of Turkey and Argentina highlight the risks of neglecting reform, building up balance of payments and financing risks, and losing market confidence.
A lessening in fundamental headwinds—as well as a more benign US approach to trade, even if no outright reversal of measures imposed—are consequently some of the signposts we are looking for in order to enter the asset class more broadly. In the meantime, being selective is the most sensible approach, especially within over-sold spread, rates, and EM FX markets.
Valuations are undoubtedly improving, but while more attractive now, they are in aggregate not yet compelling enough. To put into context, the sell-offs year-to-date have been large in terms of magnitude but are on balance below the average seen throughout the most severe EM crises in recent history and far off the worst-case episodes (Figure 5). This gives some idea of further downside in case an escalation in trade wars or faster US rate hikes – our risk scenarios – materialise.
The main changes to our asset allocation views this quarter have been a slight reduction in the equity risk and a small increase in our long USD bias versus a range of currencies. Our overall allocation to government bonds remains underweight – we hence currently prefer to take risk via short duration as opposed to long equity risk. Credit remains in aggregate underweight given comparably expensive valuations.
Our long held cautious stance on Australian assets, because of domestic vulnerabilities coupled with Australia’s high sensitivity to EM stress, has played out well. With little priced in terms of RBA rate hikes and slim chances of rate cuts, and Chinese fiscal and monetary stimulus working through the real economy with a lag, we expect that most of the adjustment in terms of a weaker currency and bond yields has materialized.
We are largely negative on other government bonds, expecting the UK’s low real and nominal yields to be pulled upward over time by BoE hikes, though Brexit worries add noise and two-way risk. Eurozone assets are also low-yielding, and though a steep curve and dovish ECB underpins prices, growth, the end of QE, and Italian risk abating mean risk-adjusted returns are not compelling; though Italian BTPs can outperform if political risks are contained. The US 10-year benefitted earlier in the year during various “risk-off” episodes, but interest rates have moved higher in recent weeks as Fed hikes approach alongside ample supply of Treasuries and Fed balance-sheet runoff.
Within the credit space, we adjusted our preference of US over euro High Yield credit in favour of euro High Yield which now returns to a neutral overall weighting. We are more cautious on the US as valuations have not yet come down, whereas spreads have widened substantially in the Eurozone based on worries over the ECB exiting QE and the Italian political situation. Emerging Market local currency debt, which was previously a small overweight position, has now been reduced to neutral given pressures on EM Central Banks to raise rates in order to protect their currencies. This latest adjustment takes the implicit EM FX risk to a slight underweight.
We are neutral on EM across asset classes in the expectation that a tighter environment for US liquidity will present ongoing headwinds across the diverse investments of the region, even as long-run value becomes more apparent. Hard-currency spreads have widened and offer ample premium to US high yield, and equities cheapened substantially but must overcome growth, political and trade concerns.
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