Markets are in a state of flux. Uncertainty emanates from both the real and the political economy, prompting a dovish pivot by central bankers seeking to stabilize markets and prevent declining business sentiment undermining the economic expansion.
The source of the economic weakness has its roots in the trade conflict that started more than a year ago and culminated with the US administration imposing tariffs on US$250 billion of Chinese imports. The fact that the last round of tariffs to be imposed came on September 24th just three days after the peak in the S&P 500 is no coincidence.
The synchronized upswing in global growth of 2017 gave way to a sudden stop in global trade in fourth quarter of 2018. The economic weakness appears to have persisted into the first quarter of this year with leading economic indicators failing to show a conclusive sign of a turnaround.
Indeed, the first batch of preliminary readings of the manufacturing Purchasing Managers Indices remained at concerning levels in March.
But for an asset allocator, economic momentum is just one key factor in any decision and by no means the only driver. Policy response, investor sentiment and valuations all play a key role. So, it has been critical to monitor the policy actions in recent months from the two main protagonists in the trade war.
China is signaling a renewed infrastructure spending push and is also seeking to stimulate an acceleration in credit growth, partially reversing the deleveraging drive of the last two years. A similarly accommodative shift has occurred in the United States, with the Federal Reserve shifting gears dramatically in recent months, culminating in the March meeting of the Federal Open Market Committee that showed no rate hikes over the next two years and confirmed that the process of balance sheet normalization (or quantitative tightening) will cease in September 2019.
Both sets of actions have conspired to boost equity markets. The S&P 500 is up 12 percent year-to-date with its 12-month forward price-earnings ratio having moved from a 5-year low of 13.6 times to 16.4 times now. The Shanghai Composite has doubled the US’ year-to-date gains, rallying by 25 percent to trade on a PE multiple of 11.2 times.
With investor sentiment and valuations having now moved closer to fair value and the policy response now underway, asset allocation decisions become more reliant on one’s growth forecast in coming quarters.
Signals from the yield curve have gained further prominence in recent weeks with the three-month to 10-year metrics recently inverting for the first time since 2007. While the yield curve is one of the best lead indicators of a recession, we believe that inversion alone is insufficient to make that forecast at this juncture.
There are two main reasons: first, the downward pressure from QE on the term premium component of the long-term bond yield (i.e., the premium investors would normally demand for holding a longer-maturity fixed-income asset has fallen from an average of 100 basis points in the years prior to the financial crisis to minus 75 basis points now) has made inversions more likely for a given level of short-term rates.
The critical question is whether short-term interest rates are above what the economy can withstand. We estimate that the current Fed funds rate is close to the so-called neutral rate and is therefore unlikely, by itself, to plunge the economy into recession.
Secondly, most economic indicators from the labor market, measures of consumer confidence, construction activity and inflation do not signal a recession is imminent. We also find it difficult to identify sources of structural imbalances that have caused prior crises.
To be sure, growth has slowed from an unsustainably above-trend rate to somewhere closer to potential, but to extrapolate that deterioration would be premature.
Although we expect the battle for global hegemony between the US and China to be a generational concern, our base case is that the de-escalation in the US-China trade conflict seen in recent months will persist, allowing global growth to stabilize close to trend.
The problem investors face is that the trend growth is itself quite low (slightly below 2 percent in the US, 1 percent in the euro area, close to zero in Japan and 6 percent in China). With profit margins already extended, trend rates of economic growth are only likely to translate into quite meager mid-single digit earnings growth and given very limited scope for valuations to expand, the strategy is close to neutral on the asset class.
We have a bias toward Asia where we can still find some value and cyclical upside to earnings expectations over the next one to two years. We retain exposure to developed high-yield credit exposure where we still believe that the credit spreads available to an income-oriented portfolio are attractive and that debt levels, while high, are manageable, given free cash flow generation and high interest cover.
The strategy continues to hold no investment grade credit as we see insufficient value in this asset class. We remain constructive on emerging market debt, preferring a selective combination of corporates and local currency sovereign debt in countries with attractive carry and improving fundamentals.
Fundamentally, slow rates of trend growth, heightened political risk and more frequent bouts of volatility mean investors need to be flexible in their approach.
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