As we think about asset allocation through the remainder of 2019 and into 2020, there are four clear themes that investors should consider.
- Despite an incredibly long cycle, talk of the end of the cycle may be premature – stay invested but prepare to be nimble.
- The search for yield continues and equities will likely still be the place to look, but think quality and more defensive styles.
- Emerging markets, despite trade risks, still have attractive valuations.
- Rates are at almost record lows and are potentially trending further down – stay short in duration and consider EM Bonds.
Stay invested but prepare to be nimble
While speculation continues around the impending end of the cycle, we think the synchronised global slowdown is giving way to signs of stabilisation, confirming our longstanding call that we are seeing a slowdown rather than a recession.
In the United States (“US”), with inflation contained and unemployment low, the likely Fed pause should help extend the economic cycle supported by patient monetary policies and more supportive fiscal policies. The US should see further upside with growth drivers remaining in place. Both our forecasts and those of the International Monetary Fund (“IMF”) point to better growth in 2020 than in 2019 (but this will require confirmation in the data). The IMF forecasts 3.3% global Gross Domestic Product (“GDP”) growth for 2019 and 3.6% for 2020 – so a similar re-run of the 2016/17 situation, but without the boost from US tax cuts.
Figure 1: Global Growth Moderates But Expansion Continues
Source: IMF, State Street Global Advisors Economics. Updated as of 24 April 2019. SSGA World Real GDP Growth Forecasts are for the 2019 and 2020 calendar years. Projected characteristics are based upon estimates and reflect subjective judgments and assumptions. There can be no assurance that developments will transpire as forecasted and that the estimates are accurate.
What this means is that the cycle could extend through 2020, with a spike in inflation followed by a severe policy response looking unlikely at this stage. As the economic cycle extends, swift changes in market sentiment will likely bring about more volatility but it will be important for investors to avoid getting distracted by the noise and stay focused on the fundamentals.
Stick with equities but look for quality
With rates moving lower – stay invested in equities but look for quality stocks and defensive styles. Key for investors will be to keep an eye on the direction of monetary policy. Global rates have been on the decline for the last 30 years.
In Australia, we have already seen interest rates drop to decade lows and expectations are increasing for future rate cuts across a number of major economies. This has had a knock on effect with the interest available from fixed income securities declining steadily in the past three decades.
Figure 2: Yields Keep on Falling
Source: Thomson Reuters, Datastream, State Street Global Advisors as at 31 May 2019. Past performance is not a reliable indicator of future performance.
Yields from 10-year government bonds currently stand at 1.41%. Cash interest rates are trending lower and the expectations are for cash rates to continue to decline1.
As investors are faced with lower and lower rates (many close to zero) they will be encouraged to invest further up the risk spectrum and into growth assets and equities.
Equity markets have so far had a strong rally. However, this has been driven by margin expansion rather than earnings expectations. Better earnings will need to come through to justify the rally. But given the low yields across fixed income, equities still look attractive.
Figure 3: 10 Year Average Earnings Yield vs. Bond Yield
Source: Bloomberg Finance L.P., FactSet. As at 31 March 2019.
However, investors should think about how they position across equities. Australian equities maintain their appeal now that the headwinds from a potential labor government and its policies around franking credits and negative gearing have been removed, but investors should still be wary.
Australian banks face further margin pressure as rates decline and the banks’ earnings outlooks deteriorate. In these more fragile times, it is especially important to focus on the quality of the investment and maybe look for strategies that are more defensive in style.
Trade risks loom but EM valuations still attractive
The re-emergence of trade risk threatens both US and global growth but while markets will be sensitive to any signs of escalations they are also aware that threats of escalation are being used as part of the bargaining tool kit. The risks of a full-blown trade war are still unclear but what it does bring is greater economic policy uncertainty and volatility.
Figure 4: Elevated Economic Policy Uncertainty
Source: Economic Policy Uncertainty – updated as of 1 March 2019.
As a result, we try to look past the noise and focus on the fundamentals. The 2019 rally up to this point has been driven by multiple expansion; further returns are needed for earnings growth to improve. Earnings revisions and expectations globally were mostly negative at the start of 2019, but seem to have stabilised in April/May.
Overall consensus expectations are for higher earnings from the Eurozone and EMs relative to the US where earnings have suffered from a tough YoY comparison relative to Q1 2018 when US companies benefited from tax cuts. We expect Earnings per Share (“EPS”) growth to improve as the year progresses (Q4 2019 consensus growth is ~9%).
Drivers for US remain in place: capex, buybacks, consumption and government spending. European markets have become more optimistic since the longer extension of the Brexit deadline, but offer insufficient compensation to justify a market position in the region with the risks perhaps being overly discounted with some indicators like GBP/USD and EUR/USD risk reversals looking too optimistic on resolution (both trading at 2017 levels).
While there are mixed views across developed markets (DM), we are wary of developed market valuations and look for better value in EM (despite trade risks).
EM valuations are +1 standard deviation relative to their own history; EM valuations relative to other regions are at all-time lows, while EPS and sales forecasts in EMs are holding up well.
Overall, we like equities but within equities prefer exposures to relatively cheaper areas such as EMs where valuations relative to the S&P 500 look attractive (the Price to Book (“P/B”) discount is about 50% and the Price to Earnings (“P/E”) discount is about 30%). Also, earnings expectations are higher (EPS growth is ~9% for EM and ~5% for DM).
Credit is late cycle and spreads are tight, so keep exposure light and focus on quality. In credit markets, yields have come down, reflecting underlying structural forces rather than a significant flight to safety or market dislocation. The 10-year US Treasury is not as attractive as it was and the market has moved in terms of future interest rates (5yr5yr) since December 2018. These are now closer to our estimates (implied neutral nominal rate) and those of the Federal Reserve (Fed long-run rate). This leads us to believe that US rates are currently close to fair value.
Figure 5: US Bonds Close to Fair Value
Source: Bloomberg Finance L.P., and State Street Global Advisors as of 18 April 2019
Short term yields are still attractive and we still like short duration opportunities as signs of excess are emerging (e.g. in leverage loan markets) and corporate leverage is high. The credit cycle could lengthen, but risks are building. In Europe, yields in the UK and Germany look rich thanks to political risk and subpar growth, but could revert higher. However, EM bonds offer value relative to developed markets with higher growth, lower debt and high yields.
Figure 6: Consider high growth, low debt, high yield emerging countries
Source: State Street Global Advisors, JP Morgan, as of 31 March 2019, for illustrative purposes only.
Overall risks may continue to cast a shadow, but with low rates and growth drivers in place, we expect to see some improvement in earnings. Positioning in markets where valuations look attractive - as they are for EM equities and fixed income - may carry some volatility, but should have a positive outlook for the longer term.
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