There are numerous current threats facing financial markets – such as an earnings or manufacturing slowdown, geopolitical tensions, the rise of populism and volatile political leaders. However, absent a sudden shock, we do not anticipate de-flation and or a recession in the near future.
This contrasts with the current investor risk-off mind-set, with global bond markets which appear to be implying a better than 50% chance of recession. Equity markets, however, seem to suggest a much lower probability of such an occurrence. So, which is closer to the mark?
A number of leading economic indicators which incorporate factors such as business surveys, consumer and labour markets, commodities and trade are pointing to a bottoming of economic momentum and some recovery into the second quarter of 2020. In addition, easy liquidity conditions should keep markets out of any mayhem for now.
A shifting landscape
While we do not anticipate a recession, we believe that the US – which has exhibited disproportionate growth compared to the rest of the world in recent years will begin to ‘catch-down’. This means that the US is likely to slow (from a higher base) at a faster pace than the rest of the world.
After countless rounds of quantitative easing (QE), the efficacy of extraordinary monetary policy has also started to wane. In Europe, for example, Germany is on the brink of a recession. Clearly, the one-size-fits-all measures are unable meet the needs of all EU countries.
In developed countries, the ‘savings conundrum’ also highlights the failure of QE to stimulate spending in the economy and boost growth. With life expectancy rising, there is a growing pool of retired people looking to make savings last longer. However, the more central banks push down rates, the more people are starting to save earlier to achieve a decent amount of retirement income. In this way, QE is sending people to the bank rather than the shops.
Although developed nations are already highly indebted, the cost of servicing debt has come down by a significant degree. Interest costs as a percentage of global economic size have declined significantly. Therefore, governments able to borrow at a negative yield are surely incentivised to do so. Moreover, the economic multiplier effect is greater for fiscal stimulus than monetary. A shift to fiscal tools is probably necessary to stimulate growth in a meaningful way. Should this occur, the outlook for growth assets would improve significantly.
In a complex environment, where many underlying dynamics have the potential to develop, it becomes more important than ever for investors to be mindful of risks in asset allocation. At a time when data is mixed, volatile market swings are likely and it is prudent to adopt a slightly defensive approach.
In the equities space, we are underweighting Europe, which is in an economic slump, and are neutral on the US, as signs of a slowdown materialise. On the fixed income side, we have a preference for inflation-linked bonds. With the majority of nominal bond yields in the developed world trading at low or even in negative territory we favour lower than average duration. Meanwhile, we believe it is best to avoid high yield or junk debt, which is the first to suffer in an economic slowdown.
To pick up yield, we have a bias to local currency emerging market (EM) debt, which will continue to be supported by central banks injecting liquidity into their respective economies. Our bias in this space is towards Asia and major EM economies.
Regarding currencies, we are relying on the Japanese yen, which acts as a natural hedge amid ongoing volatility. While the US dollar may hold up in the short term, the US “catch-down” thesis together with the Federal Reserve’s accommodative policy should reduce support for the dollar in the medium to longer term.
We are also using alternatives to pick up yield, which further strengthens diversification. Infrastructure currently offers appealing return prospects, as does global listed real estate.