Getting the right asset mix when markets send mixed messages
Central banks have made their moves. Politicians have delivered key announcements. What do these mean for financial markets for the rest of the year and into 2020? On 31 July, the US Federal Reserve announced its first rate cut in a decade, and hinted more could follow. Earlier in the month, the European Central Bank signalled another U-turn; it could see both rate reductions and renewed quantitative easing in the coming months. At the start of August, President Trump surprised markets with the announcement of a new round of tariffs on consumer goods if trade talks with China did not reach a speedy conclusion.
It is no surprise that the tariff news caused another bout of profit taking. Equity prices have performed extremely well during 2019. The US stock market has risen nearly 20% year-to-date, and most major markets are up 5-15% in dollar terms. These are some of the most robust returns since the global financial crisis over a decade ago. Bond investors have done well too. Holding the benchmark (reference index in France) 10-year German government bond or the equivalent US Treasury bond since the start of 2019 would have returned about 8-9%. As yields collapse, so bond prices rise.
Many commentators have asked how this can be the case – surely either the equity or bond markets must be mispriced? The answer is no.
The backdrop is that the world economy has been slowing noticeably since late last year. Major worries about a trade war – mainly between the US, China and Europe, but also including Mexico, Japan and Korea – have combined with other headwinds to slow global activity. One cause was the lagged effects of previous attempts at debt deleveraging in China. Another was the stronger US dollar, which is a headwind to emerging market (EM) activity. A third was a cyclical downturn in major industries such as cars and smartphones. The outcome was global trade growth slowing to about zero, weaker business confidence and unfortunate delays to corporate investment. Pressures began to build in financial markets; recession worries reappeared.
Over recent weeks, it had appeared that better news was starting to emerge on the trade front. The agreement between presidents Xi and Trump on a trade truce at the G20 meeting calmed market nerves. The prospects of a deal were reawakened. Alas, it wasn’t to last long. To the dismay of many, ‘constructive’ US-China trade talks ended on 1 August with no agreement in sight. The situation then sharply worsened, after President Trump announced fresh tariffs on another US$300 billion of Chinese consumer exports, effective 1 September. This latest development underlines the volatile nature of the talks, and the strategic rivalry between the two countries.
What for the future? Our forecasts are for similar global economic growth in 2019 and 2020 – potentially 3%. Inflation pressures look limited in this environment, even if wage pressures are emerging in some countries due to record-low unemployment. This is not a superb backdrop for further strength in equity or bond markets. However, it is a world away from the recessionary risks seen last autumn.
The key issue for companies will be whether they can grind out steady profits growth into 2020.
Strong cost controls and productivity growth will be the order of the day to protect margins. As such, the timing of future interest rate cuts will be important to revive business confidence.
Getting the right asset mix
As for investors, one option in the current environment is to hold a diversified portfolio of assets. Starting with equities, positive profits growth should support both developed and emerging markets (EM). However, EM equities appear to have higher risks – whether from a return to trade worries or a sharp rise in the US dollar. With the US presidential election approaching in November 2020, there is a strong possibility that Mr Trump could use his favourite weapon of tariff threats with more countries. This might help him to demonstrate to the US electorate – notably blue-collar manufacturing workers – that he is working hard to “Make America Great Again”. That said, threats are different to an actual trade war and few expect even Mr Trump would spark such a confrontation in an election year.
Within EM equities, Asia looks set to benefit from further Chinese stimulus, which looks likely. Stability remains the watchword for the Chinese government in this important anniversary year for the Communist Party. Several countries such as Vietnam or Korea could also benefit from any plans by US firms to move operations outside China. Many companies, under pressure from the US administration, are already looking to reorientate their supply chains.
Interest rate cuts tend to be a good backdrop for buying assets with yield, carry or spread.
This explains the rationale for holding high-yielding corporate bonds, notably in the US and Europe. EM debt is also an option. Of course, investors need to be selective, although the problem countries like Venezuela or Turkey do not dominate EM debt markets.
In our view, it doesn’t make sense to take too much risk in government bond markets when valuations are stretched. After all, we saw after a recent stronger-than-expected US employment report just how quickly investor expectations can change.
A look at the alternatives
Alternative assets can also provide income in a world of low interest rates. Real estate is one example, although again care must be taken. The retail sector is under pressure in many countries, noticeably the US and UK, due to the inexorable rise of e-commerce. On the other hand, in many economies there is strong demand for office space, data centres, logistics sites, hotels, student and residential accommodation. The key, as ever, is location – and whether supply is growing ahead of demand. Housing bubbles are starting to form in some countries such as Germany, while others like Canada and Australia are seeing more difficult conditions.
In the current environment, equity income funds are another possibility in a diversified portfolio. Dividends yields are often high, particularly in the UK and Europe. Further, investors can sometimes benefit from share buybacks, a trend most prevalent among US and UK corporates. There is also the positive impact of M&A activity, where again the UK is leading the way. The cumulative effect can be significant. While the global equity market index has risen about 100% in price terms in the course of the last 15 years, the total return is about 200%.
Last of all, we turn to currencies. There are few strong signals from valuation models at present. Some EM currencies are expected to see moderate weakness in the coming months as interest rate cuts take effect. The dollar could potentially drift lower, with further interest rate reductions reducing its carry attractiveness. The one currency that could prove volatile is sterling. Brexit uncertainty in the first weeks of Boris Johnson’s premiership has caused the pound to approach previous lows against the euro and US dollar. Further upheaval is likely as the 31 October exit date approaches.
A final word of warning…
Last year was dominated by volatile markets. This year has seen more concerns about geopolitical risks. The world economy is growing slowly and additional central bank support is required to justify current valuations. We would not be surprised to see sharp rallies and sizeable sell-offs as global investors react to a complicated mix of economic, corporate and political signals. Diversification and flexibility with putting cash to work look the order of the day.
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Andrew advises the Chief Executive Officer and the senior fund management team with economic, market and political analysis. He is a member of the Global Investment Group forming the House View, as well as part of the Multi Asset and Macro...
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