Five Key Themes - And How To Play Them
The first half of 2019 is behind us. The MSCI All Country World Index (ACWI) returned 16.6% in US dollar terms over the first six months of the year1 – the highest return in the first half of any year since the index’s inception. Most fixed income indices – across government bonds, investment grade credit, high yield, and emerging markets – have delivered handsome returns as interest rates have fallen from already low levels, and spreads have narrowed from already tight levels. The first half of 2019 was a good one for investors.
Now, as we’re looking ahead to the second half of 2019 and into 2020, investors face a range of challenges as well as opportunities: a slowing global economy in a mature economic cycle; central banks preparing for stimulus; low or negative interest rates; steep valuations; and a myriad of geopolitical concerns. It is easy to get scared.
We’ve narrowed these down to five key themes that we believe will continue to dominate headlines and drive the performance of financial assets in the second half of 2019 and the first half of 2020.
At a time of the year when many investors review their portfolio positioning as secular changes impact nearly all aspect of our lives, we outline our investment ideas to help navigate the environment ahead.
Theme 1: Slowing economic growth, the end of the cycle – Finding growth in a low growth world
This current expansionary stage of the economic cycle is the longest on record. A mature cycle does not end just because of old age. Typically, recessions begin because of: significant imbalances in the system; rising inflation and aggressive central banks; or a confidence shock leading to a collapse in demand. As long as we cannot be certain that we have any of the above – or indeed that we do not have any of them – predicting the end of cycles and the beginning of recessions are notoriously difficult.
Global economies are slowing down – slowbalisation; debt levels are high and rising; inflation remains stubbornly low, although the labour market is tight; short-term and long-term interest rates are low or negative; and corporate earnings are losing steam after a roaring 2018. As time goes by, investors are increasingly concerned about an economic contraction – with every day that passes, we are one day closer to the end of the cycle.
We have not yet identified any clear signals that a recession is imminent. The cycle could continue for another 12-24 months, or perhaps longer with the help of policymakers. Investors who need their portfolio to generate returns must invest – they do not have the privilege of pulling out and risk missing out on a potential final upward-leg of 25% in equities, in particular when cash and government bonds offer meagre returns. Nobody wants to be the one who stops dancing before the music stops.
The three investment ideas here are: to maintain diversification, to maintain exposure to defensive investments (because we do not know when recession hits) and to favour investments offering growth and income because they are likely to be attractive in a low-growth, low-yield environment.
Theme 2: Monetary policies – End of the hiking cycle, beginning of an easing cycle
Now that the US Federal Reserve (Fed) has paused its hiking cycle of policy rates, an easing cycle may ensue, depending on data. Never in modern history has an easing cycle begun with the 10-year Treasury yield so low (currently around 2.0%). Meagre inflation, political pressure, and the fear of a recession are all potential reasons for the Fed to ease. No group of Federal Open Market Committee members wants to go down in the history books as the one that derailed the global economy. A lot is at stake.
The situation is different for other major central banks – the European Central Bank (ECB), the Bank of Japan (BoJ), the Bank of England (BoE), and the People’s Banks of China (PBoC). They have not had the opportunity to begin a hiking cycle, and they are considering easing and stimulus. Just as we thought that markets were beginning to get over their addiction to quantitative easing, easy money and stimulus, they relapse. Policymakers do not want the economic cycle to end under their watch.
The three investment ideas here focus on currencies, high-quality fixed income and risk assets. A renewed easing cycle may have a profound impact on all these asset classes. The risk is now that the markets expect easing, if central banks fail to deliver the disappointment could lead to a selloff. The key risk is a surprising jump in inflation, leading to a realisation that central banks are behind the curve and raising expectations of faster tightening. In this scenario, a correction in both equities and bonds could occur. This would be problematic for portfolios relying on a negative equity/bond correlation for diversification. Higher US yields could also mean a strong US dollar, providing some protection to clients exposed to US assets.
Theme 3: Fixed income – The new abnormal and the role of bonds
We are truly in uncharted territory. Not only have some equity markets recently (once again) reached all-time highs, but also the yields of some government bonds have recently (once again) reached all-time lows. The German 10-year bund yield has reached a level below -0.35% for the first time in history. Some investors need safe-haven assets to hedge liabilities so much that they are willing to pay the German government to keep their cash, instead of earning an interest on it. The yield of French 10-year government bonds fell below zero for the first time. Now, investors who lend money to the French government get paid back less than they have lent. The yields on 10-year Greek bonds reached over 25% in the 2011 Eurozone debt crisis. Now, the 10-year Greek yield is roughly the same as the US 10-year Treasury yield.
The ‘new normal’ for government bonds was supposed to be ‘lower-for-longer’ rates. Globalisation, technology and demographics can all explain a world with modest inflation and modest economic growth, justifying low government bond yields. But negative yields are not a new normal – they are abnormal. With central banks pivoting to easing policy, economic growth slowing down, and inflation remaining low, the negative yields can turn even more negative.
The three investment ideas here focus on the role of high-quality bonds in multi-asset portfolios. The traditional roles of bonds were to generate income – which does not work with negative rates – and to diversify equity risk. Protection from bonds is limited when rates are low – how much further can they fall? – and it is expensive to pay interest on bonds rather than collect interest from them.
Theme 4: Valuations – When expensive is too expensive
Many financial markets are at historical extremes – either highs or lows. Years of unconventional monetary policies have pushed interest rates lower and asset prices higher. Valuations mostly matter over the long term – although they can impact short-term sentiment – and at extremes.
Public stocks are arguably not overvalued because earnings have kept up with prices and they are not as expensive as bonds. However, it is difficult to argue that bonds are not overvalued when rates are so low and spreads are so tight. Higher prices today mean lower returns tomorrow. Excess returns – alpha – from active management become more precious when market returns are modest.
At times like these – rich valuations, a mature economic cycle – investors tend to become increasingly nervous. And investor behaviour can become paramount. Our three investment ideas focus on how investors should behave during these stressing times. Uncertain times require a diligent and clear head, calmness in the face of volatility and the unknown, and not being too brave.
Theme 5: Geopolitics – Technology, politics, demographics, trade wars
During normal times, geopolitics can create a lot of noise – but they normally have limited impact on the long-term performance of financial markets. We are not living in normal times.
What we are living through is a number of secular shifts in society – a digital revolution, a political revolution, and a demographics revolution. Technology impacts nearly every aspect of our lives – the way we work, shop, bank, commute, communicate and so on. Populism seems to have changed Western politics and our values. An ageing population may mean that the Japanification of Europe will follow. Things are changing, and they are changing fast.
Global trade disputes between the US and China – and perhaps Europe – are set to continue impacting the global economy, supply chains and corporate earnings. With the 2020 US general election on the horizon, we believe President Trump is likely to try to reach a deal with the Chinese. European politics – Brexit, the situation in Italy – are likely to have a major impact. Regardless of how the Brexit saga ends, one certainty is that its end will remove some uncertainty and markets hate uncertainty. Another geopolitical risk is an escalation of tensions between the West and Iran. Although the oil price is not as sensitive as it used to be to the situation in the Middle East because new technologies offer abundant energy sources in the US, a war could still impact oil prices.
In this complex environment, our investment themes focus on what can go wrong in case of deterioration and what can go right in case of resolution.
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