Asset Allocation

The famous 1915 illusion called “My Wife and My Mother-In-Law” is an apt illustration for what is happening at the moment in financial markets. Some people see the young “My Wife” while others see the “Mother-in-law”. The same data presented in the same way is interpreted differently depending on which asset class you are invested in and over which time period. 

The different perspectives goes to the heart of how each investor thinks. Equity investors are naturally optimistic because to get a return they need positive growth and earnings. Bond investors don’t really care about the upside, they just want their capital returned plus interest.

The current low interest rate environment, and assurances from central banks that rates will be held lower for much longer, is seen as positive for equities because it means discounted future earnings are higher today than otherwise would be the case. This makes equities more attractive today.

This is true of course, but to be sustained, equities also need growth. If interest rates are moving lower because the outlook for economic growth is lower, then the optimistic case for equities begins to fade and the young girl turns into the old lady.

This is partly what we saw last week. China’s move at the start of the week to devalue its currency escalated the US-China trade dispute to a new level. What was previously seen as a step too far is no longer so. China sent a shot across the bow to the US in retaliation to higher tariffs on its imports into the US.

An escalation in trade tensions equates to an extension in the dispute. It now seems even less likely that a resolution will be found this side of the 2020 Presidential Election. This is important because the longer the trade dispute lasts, the more damage it will do to economic growth. Confidence is sapped and decisions to invest are delayed or denied altogether.

All about growth

If growth begins to slow, earnings growth will slow. This means even with a lower discount rate, the present value of earnings will be lower.

Even before the recent escalation in trade tensions economic growth was easing. Global manufacturing surveys in the US, Europe, China and Japan all point to shrinking manufacturing activity. Industrial production, trade volumes, new export orders, business investment, residential construction activity, and freight volumes are all showing a weakening growth trend.

Lower economic growth expectations have been a feature of central bank forecasts for some time. These forecasts are now being revised down to even lower levels as we saw in Australia last week. This is despite still relatively strong labour markets. We need to remember, however, the labour market is a lagging indicator. Cutting staff numbers is usually a last resort for a company feeling the pressure of weaker demand because it can be so costly and time consuming to re-hire.

The early evidence of weaker economic growth first appeared among manufacturers. This is the sector most exposed to the trade cycle. There is growing evidence to suggest the weakness in manufacturing is spilling over into the services sector – a much larger share of most developed economies.

A spillover into services makes sense if the slowdown in manufacturing is long-lasting. The barber, the café owner, or the motor mechanic will be impacted by weaker trade if their manufacturing neighbour decides to close its doors for example.

Oil is the canary in the coal mine

There are many factors contributing to oil’s decline – the decline in Chinese economic growth, soaring production in America and the strong U.S. dollar are a few of the top reasons. An escalation of the trade dispute, and indeed a broadening of the dispute to include Europe, would cause the oil price to fall even further as global aggregate demand falls.

A weaker oil price is typically one of the early indicators of weaker growth because oil quite literally greases the wheels of the economy. Back in the 2015-16 slowdown, the price of oil fell to below $30 per barrel. Today, the price of West Texas Intermediate is around $55 per barrel.

The implications of a weaker oil price are significant. Exporters of the commodity will suffer lower terms of trade, weakening national income levels. The largest oil exporters are Saudi Arabia, Russia, Iraq, Canada, UAE, and Iran. Australia will be affected indirectly since LNG is now our second largest export and the price of LNG is tied to that of oil.

The energy sector in general will be affected as earnings fall. This will impact the equity market but also the high yield market where energy is a large weight.

Perspectives change

The charts below show the performance of the major asset classes with chart 1 showing year-to-date performance.

Chart 1: Year-to-date returns (%)

Source: Bloomberg. Data as at 9/8/19

Bonds, equities, commodities and the US dollar are all up significantly over the period.

Falling bond yields, higher capital returns, reflects an expectation that central banks will be keeping interest rates lower for much longer. Equity returns are higher as lower bond yields allow investors to apply an ever higher valuation multiple to the earnings that businesses can generate in the future with stable growth. Similar to equities, commodities are priced for stable growth.

The second chart uses the same data but the perspective is changed. These charts show performance over the past quarter-to-date.

Chart 2: Quarter-to-date returns (%)

Source: Bloomberg. Data as at 9/8/19

The difference reflects the change in view on growth. Bonds and the US dollar are still positive, given expectations for central banks have not changed, but equities and commodities are weaker.

Quarter-to-date, fewer equity and commodity investors are optimistic about the outlook for growth. The recent escalation in the trade dispute raises questions about the sustainability of global growth. This is what the decline in oil prices is alluding to. In this environment, equities will struggle.

We will be watching closely how central banks around the world respond to the latest events. Responding in speed and size will be more important in counteracting any impact on growth than a slow response. This is particularly the case when monetary policy is operating so close to the zero interest rate line. “Go big, go households” was the response by Australian policy makers during the Global Financial Crisis. And it worked. This time, in the absence of fiscal stimulus, central banks need to “go big, go now”.

We remain defensively positioned

We remain defensively positioned with an underweight to equities both domestic and international and an overweight to fixed income and cash. In our underlying manager selection we are focused on low volatility strategies, preferencing large over small cap managers, diversified over concentrated funds, and have rotated some of our alternatives exposure out of hedge funds into gold and infrastructure. 

Tracey McNaughton

Thanks for your comment Harry. Right now, more than ever, cash is the only safe haven asset. Gold if you don't trust the system. Your point about the tulip bubble reminds us that investors are not always rational. Buying a negative yielding bond doesn’t seem so crazy when put into context of buying a flower for what it would cost to clothe, feed and house a small Dutch village for a lifetime. Still crazy nonetheless.

Jonathan King

Well written article - like the play on perspective.


Hi Tracey. You mention in your response to Harry's comment that cash is the only safe haven asset. The RBNZ recently "went big, went now" on the OCR with the immediate impact on the $NZ. It appears the major currencies are starting a 'race to the bottom'. How will cash remain a safe haven asset if its buying power is significantly devalued?

Mark Mose

Things that make you go hhhmmm... Thanks for the article Tracey. However, going to cash seems to be an indecisive fear response to me, and a little bit of desperation, and it's a loss making strategy, because every day currencies around the world are racing to devalue. I wouldn't rule out the RBA taking some unprecendented intervention, and Australia sinking to zero bound rates for many years into the future. Bond yields suggest a recession is on approach, in the next 18 months, and the Chinese printing presses won't save Australia this time, especially with the private debt bubble that much bigger. A more profitable approach in my opinion, would be to go to gold and home property, for those who can do so without having to borrow much. For the rest, while interest rates are low, I would be paying off debt. Home prices have reached a bottom, and there are bargains, and tax concessions, for those who are cashed up and don't need to borrow. Gold is an obvious one, and will probably go to USD$1,600 and above, and keep on climbing. Yep, keep a little bit of cash, for sure, but realise that it's losing you monetary value every day, and depreciating your wealth. If you can take those losses, then fine, otherwise do the hard yards of research, and look for alternatives in my opinion. Thanks again.

Robyn Fortescue

I always read and think of these articles in the context of my own situation and how my humble investments would perform in this current volatile environment. When to sit low and when "to go". Yes, the comparison charts are a great perspective...