Asset Allocation

Adaptation is necessary when an environment becomes less favourable. So, as the global outlook assumes a gloomier cast, we believe investors should look beyond the comfort of conventional asset classes and bolster their portfolios with less familiar – and less correlated – assets.

Secular stagnation?

Recent headlines provide no shortage of alarming developments: a lurch towards protectionism, the fractious Brexit process and the broader rise of populist politics across the globe. Certainly, there are few signs that the underlying drivers of populism are waning. This means that investors will need to contend with political risk and its fallout for a long time to come.

Investors will also have to factor in weaker long-term growth rates in many economies.

We already see signs that ageing populations are weighing on growth across a range of developed markets and even in some emerging markets. Meanwhile, there is clear evidence that labour productivity is rising at a slower rate, providing an additional headwind for growth. The upshot is that the speed limit for the global economy looks to be stuck permanently lower.

The combination of low growth, weak inflation and low interest rates has prompted renewed interest in the concept of secular stagnation. This argues that the global economy is stuck in a rut because of an excess of saving over investment, even with such historically low interest rates. Another way of putting this is that weak growth reflects a shortfall in aggregate demand, rather than just supply issues. The debate over secular stagnation remains an academic and political one. Nevertheless, there are few signs that policymakers are set to deliver the comprehensive policies and major reforms required to rouse the global economy out of its funk. Hence, low growth, inflation and interest rates are likely to define the investment environment for the next five years and possibly beyond.

… and short-term wobbles

Stepping aside from the challenging long-term backdrop, the short-term picture has certainly soured. US-China trade tensions have steadily escalated, and there have been unfavourable political developments in countries such as the UK, Argentina, Turkey and Iran. Protectionism has taken its toll on global trade and production, with indications that some of this weakness is starting to seep into the services sector. Inflation remains stubbornly subdued in many markets, casting further doubt over the credibility of central banks’ inflation targets.

Another cause for concern is that the current business cycle is now mature. Unemployment is low in most countries and there is little spare capacity left. Corporate profit margins are coming under pressure in this environment, especially as the boost from large US tax cuts wears off. Investors are naturally becoming more fearful that the end of the cycle could be nearing.

Central banks to the rescue?

All of this paints a pessimistic picture. Fortunately, the world’s central banks are taking action. We expect the US Federal Reserve (Fed) to cut interest rates again to a target range of 1.25-1.5%. This would take the total adjustment in the Fed funds rate to 100 basis points below its early-2019 peak. Meanwhile, the European Central Bank has announced a package of easing measures, including rate cuts and open-ended asset purchases (QE). It is likely to take further steps before year-end. Indeed, more supportive policy settings should be the rule, rather than the exception, across many countries. We expect further action by central banks in Australia, Canada, Brazil, China, India and Russia in coming months.

Such measures should help cushion the shock to business sentiment that’s affecting the global economy. It is partly thanks to these central-bank interventions that we expect the global economy to avoid recession. But we are not the only ones to expect action. Financial markets have already priced in significant monetary loosening by central banks. Indeed, there could be more fiscal stimulus in 2020 as politicians look once again at their tax and spending programmes.

Persistently low growth – with risks to the downside

Although the world should be able to avoid recession in the next 12 months, growth looks likely to remain stuck at low levels for at least the next few years. Even then, there is a risk of negative surprises. Although a rapid resolution to the US-China trade dispute previously looked possible, hardening attitudes on both sides and the imposition of additional tariffs make that less likely. Indeed, we believe that risks are tilted towards further escalation, which could prove even more of a drag on the global economy.

Sub-zero

How should investors position themselves in this environment? We argue that as well as changes to the conventional assets held in a portfolio – bonds and equities – the balance between public and private markets needs to alter too.

In fixed income, a defining feature of this environment is the expectation of very low returns from government bonds, a large proportion of which have yields in negative territory. This stems partly from economic factors like the long-term deterioration in potential growth and inflation discussed earlier, as well as the short-term fears of recession, but also from the unconventional policies pursued by central banks trying to keep the global economy afloat. As a result, returns from many other asset classes are likely to be depressed too, as their ‘risk premia’ will be added to a very low risk-free rate when investors price assets.

Equities under threat

Returns from equities are also likely to be muted. The late stage of the business cycle and the lack of room for corporate margin expansion suggest that stock market returns will be below their long-term average. On some measures, equity valuations are elevated. Nevertheless, in our opinion, equities still offer higher return potential than bonds. In Europe and the UK, almost all companies in the FTSE 100 and Euro Stoxx 600 indices have higher yields than those available from corporate bonds in their respective countries.

For stock-pickers, there will still be opportunities, especially when business models are under pressure or new technologies create business opportunities. In particular, a number of structural themes will help generate returns for investors.

One of these is climate change. A huge transition in energy generation is now underway, with the arrival of cheap renewable energy, the drive for energy efficiency and the shift to electric vehicles. This will create winners and losers across the economy. On a ten-year strategic horizon, investors will be well advised to position themselves for the transition.

Adding new assets

With elevated risks for recession and sub-par equity returns, the traditional response would be to rotate to government bonds. But ultra-low yields mean meagre returns and limited defensive value, so less familiar sources may be preferable when attempting to diversify returns.

Other assets are available with low correlations to equities that should deliver similar resilience and diversification benefits to portfolios, but offering significantly better return prospects.

Among these diversifying assets are local-currency emerging market bonds, asset-backed securities and illiquid assets, especially infrastructure debt and equity.

Attractive yields

The long-term prospects for local-currency emerging market debt (EMD) are unusually strong at present. At a time when many developed market government bond yields are close to or even below zero, projected yields on EMD are almost 6%. Furthermore, our analysis shows that emerging market currencies are fairly valued, enhancing the attractiveness of the asset class.

Yield is also an important attraction of asset-backed securities and other less liquid credit assets. Asset-backed securities offer wider spreads for the same credit quality. This compensates investors for the greater complexity and more limited liquidity of these asset classes.

Real returns from real assets

There is increasing investor interest in private markets – private equity, private debt, infrastructure and real estate – which are providing attractive returns relative to public markets. The previously high yields available from these assets have been compressed by strong demand. Nevertheless, our analysis shows they continue to offer good return potential and – crucially – a lack of correlation with equities. This should prove especially important as we move through the latter stages of the investment cycle.

Stepping out of the comfort zone

A sober assessment of the outlook over the medium term should encourage many investors to move beyond conventional asset allocation. In the past, a switch from equities to government and investment-grade bonds was considered the best response to the latter stages of the business cycle. But, given the rise in political risk, and subdued long-term economic growth prospects, less familiar assets are likely to prove a better source of comfort by improving the potential returns from a more diversified portfolio.

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