Finding refuge in challenging markets

After a strong first half of the year for investment markets, recent months have crystallised both a weaker path for economic growth globally and a rising trajectory for geo-political tension. Investors are now being challenged by equity markets that appear expensive as company earnings trends disappoint and by bond yields that predict a significant global downturn and a return to ultra-low yields not seen since the global financial crisis (GFC).

At Crestone’s most recent investment forum, we asked panellists to discuss if the unfolding central bank stimulus would stabilise global growth as we enter 2020, or whether the recent re-escalation in the trade dispute, and resulting global capex uncertainty, had already set in train a near-term recession. Participants broadly see the global growth backdrop as fundamentally healthy, despite rising geo-political risks—though slower growth and lower interest rates are likely to persist. Following the housing downturn and recent policy support, Australia is seen to be in a better position to weather any global downturn that may eventuate.

Overall, investor caution was a key message, with a focus on making sure capital was deployed to companies with strong balance sheets and resilient earnings growth, while active managers are seen to be uniquely positioned to outperform. Ensuring portfolios have enough duration and are positioned for an ongoing volatile and sustained low-yield environment is also seen as key.

Where are we in the economic and market cycle?

This year has blown hot and cold from both a geo-political and macro-economic perspective. On balance, global growth has trended slower, while the heat in the key geo-political hotspots has increased. We asked our panellists where they feel we are in the current macro cycle, whether the US-China trade war has already sown the seeds of a recession, and what the single biggest risk is facing the global economy.

The case against entering a near-term global recession

According to Michael Buchanan, Deputy Chief Investment Officer at Western Asset Management, the longevity of the cycle has been unique, but the severity of the cycle is different. With global corporates and consumers still in a favourable position and contributing to a healthy backdrop, Buchanan is not anticipating a slowdown nor a recession in the near term: “While we are late cycle, there are no signs that things are turning for the worse. The severity of the crisis in the GFC has been a driver of this prolonged cycle. Unprecedented central bank action and regulatory measures to shore up the financial system have also translated into this unique cycle. There is still a reasonably healthy backdrop with global growth continuing in the 3% region.”

The single biggest risk is a shifting of the guard

Anne Anderson, Head of Fixed Income and Investment Solutions Australia at UBS Asset Management, feels we are already in a mini slowdown. Cycles have been redefined, particularly with the shift from manufacturing to services. Having said that, it would be highly unusual for the US to fall into a recession from where we currently are. Anderson feels the single biggest risk is the US and a shifting of the guard as growth in emerging markets converges on developing markets. This convergence results in an overall lower global growth outcome and in a structural shift that makes the volatility set quite unique.

She feels that, while bond markets and the recent yield curve inversion may not be as reliable as a recession indicator, this has to be managed carefully. Central banks seem attuned and aware of this fact, which is a good starting point. With central bank support, we could very easily see the cycle roll on.

The outcome of US-China negotiations will be crucial 

Domenico Giuliano, Deputy Chief Investment Officer at Magellan Asset Management, emphasised the importance of separating short-term cyclical issues from long-term trends. Longer term, expectations are for much lower growth rates than we’ve seen for the past half century. In the short term, the outcome of US and China negotiations will be crucial. While there are clearly some headwinds, parts of the US economy are still healthy and there are obvious imbalances in Europe.

Frank Uhlenbruch, Investment Strategist at Janus Henderson Investors, added that tariffs are detrimental from a net wealth perspective with everyone worse off. He expects central banks to remain fully supportive to offset trade headwinds. 

“It’s been a unique period where we have tight labour markets but low inflation. Once inflation starts to come through, the dynamic might begin to shift. Until then, monetary and fiscal policy is likely to step in to help remove any slack.”

The Crestone view: The recent US-China trade war escalation, and other geo-political disruptions, are unlikely to help key trade and manufacturing data improve in coming months. We have recently recommended a more defensive positioning in portfolios, moving moderately underweight equities and overweight cash, with a continued focus on alternative assets.

What does this mean for equities? 

Concerns over slowing global growth have been balanced by dovish forward guidance and outright policy easing from central banks globally. This has driven investors to pay above-average valuations for luke-warm earnings growth. We asked the panellists what this means for equities and whether this valuation support is justified.

It's important to mitigate company-specific risk

Nathan Parkin, Investment Director at Ethical Partners Funds Management, highlighted the importance of mitigating company-specific risk in the current environment. 

“Valuations are particularly worrying given earnings aren’t coming through.”

As a starting point, Parkin feels that removing or avoiding companies with very high debt is paramount. In Ethical Partners’ investment process, around 10% of the S&P/ASX 200 index is removed because it has too much debt. Even if the companies are paying yield, it is important to note some are not paying it out of cashflow but by borrowing more money. While they may have been the best performing companies, Ethical Partners would not own them because they are too geared. According to Parkin, given where markets are, it seems lower levels of growth have not been considered with valuations merely being supported by lower interest rates.

Parkin worries about a scenario where growth expectations become more realistic. “Earnings expectations for the 2020 financial year have fallen while bond markets have rallied through that. Unfortunately, good balance sheets haven’t really helped at all in that environment—but at some point it will become important, particularly when bond yields get off the floor. Expectations around domestic cyclicals are so low and valuations are so cheap.”

Opportunities still exist but beware regulatory risk

Giuliano mentioned that the opportunity set still exists and he has been putting money to work since the beginning of the year, reducing his cash exposure from 14% to 8%. This has been primarily targeted at ‘disruptors’, such as Google, Facebook and Microsoft. He also takes a long-term view on some of the structural themes and where the long-term discount rates might be. 

“Companies that can earn above the nominal GDP growth rate for an extended period of time with discount rates going down, that’s potentially an incredible opportunity.”

Having said that, Giuliano is cognisant of the regulatory risk in some of these companies. “In terms of defensive plays, you have to be careful around companies that are not able to grow. You have to take a long-term view of what defensibility actually means because the disruptors are trying to cut their lunch.” He is careful to acquire defensives that are not prone to disruption. In terms of sectors, he is less optimistic about financials as it is likely to become more challenging to make money given the path yields are on.

Why have active managers found the current environment so hard? 

Scott Haslem, Chief Investment Officer at Crestone Wealth Management, highlighted the tough environment active managers have faced, particularly in Australia, and Parkin commented that the narrowness of the domestic equity market has been a challenge for active managers. However, he takes comfort in the fact that active managers have some sort of valuation discipline.

“Alpha opportunities are primarily in the small and mid-cap space where manager skill can be a differentiator, with valuations particularly challenging in large caps. Good companies trading cheaply that can still grow are the focus. These companies will re-rate over time.” Parkin emphasised it is important to stick to the process to avoid underperforming on both sides of the cycle.

Buchanan highlighted it is a global phenomenon and that in fixed income, investors in passive funds end up with the biggest exposure to the most indebted companies: “You actually want the opposite of that with more ownership of companies that are delevering. In fixed income, active managers are uniquely positioned to outperform going forward.”

Giuliano reinforced the importance of not just focusing on the upside but also the risk protection provided by active managers, as they need to offer a differentiated risk profile to outperform.

Is there still an argument to invest in Emerging Markets despite headwinds?

Haslem summarised some of the risks around emerging markets, including the US-China trade dispute, tension in Hong Kong and oil issues. He asked panellists what role they feel geo-political tension plays in this—and if companies’ ability to operate profitably is being impacted.

Buchanan agreed that there is certainly no shortage of things to be anxious about. 

“It is important to be more selective when investing in this space. Fundamentals in spread sectors are quite appealing, whether it’s corporate credit, bank loans, or local currency emerging markets.”

Although cognisant of some of the market risks, Giuliano is focused on the opportunity set, outlining what happens to spending patterns when the middle class becomes more affluent. “As an example, one just needs to take a look at luxury brand LVMH to get a sense. These thematics are real. There are still opportunities out there.”

Uhlenbruch observed that “if globalisation benefitted emerging markets, then the reverse of globalisation could be detrimental.”

In the context of shorter-term risks, it is important to differentiate between business profiles, opportunities and valuations. Having said that, it is hard to understand where things might go with the China story. Giuliano noted that he does not expect China to digress from some of its strategic ambitions over the long term. He asserted that, heading into a US presidential election, we could see a transactional treaty that includes subsidies. However, increasing escalation of risk is possible and would be terrible for markets.

The Crestone view: We have recently moved moderately underweight equities. This is particularly due to the uncertainty surrounding the recent trade war escalation, but also because of the weakening trend in earnings growth. Quality and strong balance sheets continue to be a key theme.

We believe the escalation of risks places more importance on active management as a risk mitigant. While there are strategic opportunities in emerging markets, it is important to be cautious and selective at this time.

How well would Australia weather a global downturn?

With building approvals and construction activity still poor, how likely is it that Australia will slip into a recession? Would a stabilisation in housing and stimulus from China be enough to support Australia’s domestic growth in a global downturn?

Uhlenbruch feels the Australian economy will perform better in the second half of 2019 than it did in the first half of the year, with growth likely to head back towards trend rates by 2021. “A number of headwinds for the domestic economy are now behind us. A bit more stimulus is expected, which means it’s not unreasonable to expect a pick-up in the second half. Core support would come from public sector infrastructure spending and business activity.” Uhlenbruch notes that while dwelling investment will be a drag on economic growth over the period ahead, the adjustment that is occurring is one where building approvals are normalising back to underlying levels after playing catch-up to earlier unexpected demand.

Anderson feels Australia is in a good position with appropriate touches to policy, fiscal flexibility and a healthy financial system. However, the convergence of emerging markets to developed markets makes the volatility set quite different. “The bond market is telling us that real yields have to be much lower, which is good news for risk assets. Inflation is likely to hit 2% but unlikely to hit 3%. The biggest threat to Australia is its lack of income growth and where we are going to get it. If we lose the consumer then this could be detrimental.”

Richard Quin, Chief Investment Officer at Bentham Asset Management, emphasised that the Reserve Bank of Australia has changed its tone quite dramatically. He feels we may have seen the airbag deployed too quickly out of fear. 

“While the situation is not quite as dire just yet, if we start to see contraction in margins, then valuations could roll over easily. If monopoly-style stocks try to extract margin in this environment, they are likely to be regulated. This is likely to come through on the pricing side at some point.”

When asked how much credit risk investors should be prepared to take and how far up the risk curve they should invest, Quin responded that loans appear cheap because they are senior and secured. However, taking a bar-bell approach is prudent, as it is not the time to put all your risk in one basket. Buchanan and Anderson agreed, commenting that parts of the market are still enjoying healthy demand.

Anderson noted, “Going out to low single B and CCC, demand has waned due to the perception we are late cycle. There are some interesting opportunities for investors who are willing to go further out on the credit curve. However, these demand more work and analysis—where the incremental yield will more than compensate for the additional work required.” Anderson added that credit exposures have to be balanced out with some duration exposure.

The Crestone view: Although growth momentum is soft, there are some signs of housing stability and tax cuts helping consumers. While we expect slower growth ahead, Australia is now more resilient to a global downturn. We are neutral domestic equities. With central banks easing and global growth steady, Australian corporate credit remains attractive and likely to remain well supported from here.

Is there any value in bonds?

Bond markets are already pricing in significant rate cuts by the US Federal Reserve and other central banks. Can bond yields fall further towards GFC lows or can a rebound in inflation support yields higher?

Now is the time to be nimble and tactical

Anderson feels this is the time to be nimble and tactical around volatility bursts. Given yields could fall further, there is a case for buying decent set-backs in yields. A lot of multi-asset investors simply do not have enough duration for this type of environment. “There are opportunities to move up and down the curve. In the US, you could go long the front end because they are going to ease. A low yield environment means that there will be a hunt for yield, which means that you’ll be buying equities, buying alternatives, those assets that benefit from the low discount rate. Inflation is just not a risk but if you think it is, it is so cheap to hedge.”

Uhlenbruch is nervous that the bond rally has gone too far. He has been perplexed by the speed and size of some of these moves. Five-year forward rates as a proxy for neutral down the track for Australia were 3.2% in November and are now 1.2%. “Bond markets seem to be pricing in the same news over and over again and if central banks don’t deliver to the level the market is expecting, there could be a snap back, which doesn’t have to be a lot to cause angst.” Quin agreed, highlighting the success of markets versus the margins that have been produced by most companies. “Margins have been excessive and a roll over could exacerbate the valuation issue. A preliminary move by central banks has essentially boosted margins and markets. Either it is required, but the other side of that is it’s dangerous if it doesn’t work.”

Buchanan highlighted that while it is difficult to zero in on where you would want to put your money, he always starts off with where he doesn’t want to put money. Developed market sovereign bonds spring to mind with over USD 15 trillion in negative yields. “There is a lot of latent risk built up in government bond markets. Inflation and growth generally suggest low rates. If we ever saw a scenario where inflation surprised to the upside, risks elevate.”

Where do we think long-term rates will settle?

Anderson starts with real cash as an anchor. “Working backwards you add back inflation expectations and that gives a long-term estimate of around 2%, albeit with a reasonable degree of uncertainty.” Buchanan noted that “growth is stubbornly low and central banks are desperately trying to lift inflation. Therefore, it’s hard to see an environment where rates are materially higher than where we are today. Even 50 basis points higher will be materially detrimental to markets— this presents a risk even though it’s not a high probability. This makes the proposition of spread sectors, particularly credit, quite attractive.”

Will credit come under pressure given spreads are so tight?

Quin doesn’t believe spreads are tight, noting that if you use 2008 as a reference, credit will always be expensive. “We used to have inflation targeting when governments weren’t fiscally responsible, now we have responsible governments, notably in Australia. But there is a lot more dispersion of markets and you really need to analyse which ones are cheap/expensive.”

Quin is not as confident about Australia on a relative-value basis. He prefers asset-backed securities and considers this market to be defensive as it has a lot of structural protection. He believes there are issues in some emerging markets, noting recent downgrades to Argentina and South Africa. Tariffs are generally inflationary despite being disruptive as it drives uncertainty.

The Crestone view: With central banks in easing mode, the path of least resistance for bond yields is lower and credit spreads tighter. However, we remain tactically underweight bonds, given expensive valuations, balanced by an overweight to credit markets.

Where do you see the biggest opportunities and risks?

Richard Quin - Chief Investment Officer, Bentham Asset Management 

“One of the safest places to generate a positive real yield is asset-backed securities as they have plenty of protection and are high up the capital stack.
Corporate profit margins are vulnerable for companies and I’m cautious about equities— particularly disruptors, given the level of regulatory risk.”

Nathan Parkin - Investment Director, Ethical Partners Funds Management 

“I prefer companies with good balance sheets. The value of a good balance sheet has been underappreciated given the low rate environment.
Companies that are very geared are to be avoided. These companies’ share prices have risen and valuations are high.”

Frank Uhlenbruch - Investment Strategist, Janus Henderson Investors

“From an asset allocation perspective, I would be square growth assets, modestly underweight fixed interest and overweight cash on a 12-month view.”

Domenico Giuliano - Deputy Chief Investment Officer, Magellan Asset Management Limited

“I like long duration growth equities or equities that are able to deliver nominal GDP plus growth rates. I’m avoiding cyclicals— particularly heavy industrials and financials. Banks will find it challenging to make money in a flat or inverted yield curve environment.”

Anne Anderson - Head of Fixed Income and Investment Solutions Australia, UBS Asset Management 

“I would be long real yield asset classes, such as global infrastructure, inflation-linked (but not on a break-even basis) and surety of long duration income. I feel vulnerabilities are in equities, specifically momentum-driven equity beta, primarily in the NASDAQ.”

Michael Buchanan - Deputy Chief Investment Officer, Western Asset Management

“I have a preference for high quality, short duration corporate bonds.
I feel there is risk in long duration sovereign bonds, particularly European.”

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