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2Q19 Multi-Asset Outlook: What's Really Changed?

April 2019 
By Nanette Abuhoff Jacobson

The big question now is how much higher markets can climb on the back of easier policy given that economic fundamentals continue to deteriorate.

Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds.


My somewhat sober assessment of the global economic cycle hasn’t changed much since the end of 2018, yet so far this year risk markets are off to one of their best starts in history. I chalk the gains up to one change in particular: less restrictive policy. In particular, the Federal Reserve (Fed) scaled back plans to gradually hike interest rates, and the worst of the US/China trade concerns seem to have been averted. I think the big question now is how much higher markets can climb on the back of easier policy given that economic fundamentals continue to deteriorate. I anchor my views to a combination of fundamentals, policy, and valuations, and my take is that the market is now fully pricing easier policy and will be hard pressed to rally much from here without a shift in fundamentals. This helps explain the number of changes in my views this quarter, all geared around my belief that investors should consider positioning their portfolios a bit more defensively. 

I would consider favoring credit over equities, and within credit, investment-grade and high-yield bonds over bank loans. I view US high yield as a potential replacement for US equities, which may have limited upside after outperforming global equities by about 150 percentage points cumulatively over the past 10 years.1 I have a neutral view on 10-year US government bonds. Within equities, the only area where I would consider adding exposure is emerging markets, which could outperform if China increases stimulus, and act as a potential hedge if I’m wrong about global growth slowing (if global growth reaccelerates, I believe it will likely be because Chinese growth surprises to the upside). Within equities, I prefer leaning into defensive factors, such as quality and safety, which have typically been found in a diverse range of traditional sectors.

 

Nanette's multi-asset views

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Change is from previous quarter. Views expressed have a 6 − 12 month horizon and are those of the authors. Views are as of March 2019, are based on available information, and are subject to change with-out notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.

Fundamentals look weaker, and central banks are responding

I believe the global economy will slow throughout 2019. In developed markets, and the US in particular, higher wages may provide some boost to core inflation, but many of the leading indicators for cyclical inflation have turned softer. Overall, I am not expecting inflation to exceed the targets of developed market central banks. Against this backdrop, central banks have adopted a dovish tone. The market is no longer pricing any Fed hikes for 2019 (Figure 1), and the European Central Bank has pushed rate hikes to 2020 at the earliest. For its part, the Bank of Japan remains committed to monetary easing.

 

FIGURE 1
Fed expectations: From a hike to a cut?
Market probability of Federal Reserve rate hike or cut by end of December 2019 FOMC meeting (%)

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Market probabilities calculated by Bloomberg based on forward interest rate curve. Forward looking statements are subject to numerous assumptions, risks, and uncertainties and actual results could differ materially from those presented above. For illustrative purposes only. | Source: Bloomberg

 

While these policy changes create a more constructive market backdrop, I fear that they almost entirely explain the sharp rally I’ve seen year to date and won’t be enough to propel risk assets higher. In currencies, I continue to think the US dollar could appreciate given that it tends to play a defensive role when growth slows and that US real interest rates remain among the highest in developed markets.

 

Compelling opportunities in credit

I have a favorable view of credit because I don’t think interest rates will rise, spreads look fair, and I believe credit could outperform equities in a slowdown. I am moderately bullish on investment-grade credit and think market fears over the increasing proportion of BBBs in the index are overblown. My credit analysts’ work shows that companies have added leverage despite the risk of being downgraded to BBB, but that these companies generate ample cash flow and could reduce leverage if needed. After years of issuing debt to buy back equity, I expect companies to focus more on deleveraging in the coming quarters, which would benefit creditors over equity shareholders. I also think a flat corporate yield curve supports shorter-duration2 credit.

I have lowered my view on bank loans to neutral as I think short-term interest rates are unlikely to rise and demand for collateralized loan obligations could wane. I would consider high yield  because valuations look relatively attractive and high yield is more closely tied to the US economy. I continue to think that US high yield may benefit from its development into a more diversified sector with improved average credit quality and a permanent source of funding for many companies.

I believe emerging-market (EM) debt provides many country-specific opportunities, especially in countries that have already gone through the painful, but important, foreign-exchange adjustment process. But I now prefer EM equities, as China is, in my view, the most likely source of a spark that reignites the global economy, and is currently a large piece of EM equity indices but not yet included in most bond indices (Figure 2).

 

FIGURE 2
China matters more for equity indices than bond indices
Market-cap exposure by country/region (%)

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3JPMorgan Government Bond Index – Emerging Market Global Diversified (GBI-EM-GD), as of March 7, 2019. JP Morgan GBI Emerging Markets Global Diversified Index is a comprehensive global, local emerging-markets index, and consists of liquid, fixed-rate, domestic-currency government bonds. 4MSCI Emerging Markets Index, as of February 28, 2019. MSCI Emerging Markets Index is a free float-adjusted market capitalization-weighted index that is designed to measure equity market performance in the global emerging markets. | Sources: JPMorgan, MSCI

 

Country and regional equity fundamentals

US 

I expect the US economy to continue outpacing its developed-market peers but to slow as fiscal stimulus fades. US consumers remain in solid shape, but I think the pace of consumption will moderate as consumer confidence has come down from recent highs. Capital expenditures seem unlikely to fulfill the hopes for a large stimulus-fueled bump, but may still add to growth in coming quarters.

I think the US administration will strike a trade deal with China that greatly reduces the chances of more tariffs, but am concerned that it may take aim at Europe next and continue to create uncertainty for businesses. I also worry that with the first Democratic primary debate just months away, the market may soon price in the significantly less business-friendly policies being proposed by some contenders.

Although I have a more favorable view of the US economy than other areas of the world, I would note that the US is not immune to the global growth slowdown and US equities have massively outperformed for years. Thus, I have changed my view on US equities from moderately bullish to neutral.

Europe

European economic growth continues to disappoint, and while some leading indicators show signs of bottoming, overall they point to further sluggishness in coming quarters. Politics—especially Brexit—will likely impact business and market sentiment, but I am hopeful that fiscal largesse could provide some cushion against the slowdown or even help turn the cycle around. With this possibility in mind, as well as cheap valuations, I maintain my neutral stance on European equities.

Japan

Japan’s economy held up surprisingly well over the last few months before finally showing signs that it was feeling the effects of the weaker global cycle. Consumers continue to benefit from a historically tight labor market and corporate Japan is in good shape. However, Japan’s economy and currency, as well as its stock market, are highly exposed to the global economy and could underperform in times of stress. I think the economy could slow further throughout 2019, especially after the planned value-added tax increase in the fall, but healthy company fundamentals and attractive valuations are enough for me to maintain my neutral view on Japan.

Emerging markets

Despite my take on the global economy, I have raised my view on EM equities from neutral to moderately bullish. While not my base case, I am sympathetic to the idea that China’s economy may reaccelerate as a result of lower interest rates, a resolution to the trade conflict, and more economic stimulus. As Figure 3 shows, lower interest rates have tended to lead to higher money supply growth in the past. Even if my base case is correct and global growth slows, China could still perform well if monetary aggregates rebound.

 

FIGURE 3
Lower rates in China could lead to increased money supply
China M15 and 5Y swap rate

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Past performance is not a guarantee of future results. Sources: Bloomberg, Wellington Management | 5M1 is the money supply that includes physical currency and coin, demand deposits, travelers checks, other checkable deposits and negotiable order of withdrawal (NOW) accounts. Chart data January 1996 – February 2019. X-axis scale range is January 1996 – November 2019 due to China 5Y swap being forwarded 9 months. China 5Y swap data: April 2006 – February 2019, (i.e., first data point for China 5Y swap represents April 2006 and final point represents February 2019); China M1: January 1996 – February 2019

 

Commodities

Because inflation doesn’t seem to be a material threat, I am less inclined to hold commodities. The supply backdrop in many commodities, including energy and metals, is supportive of pricing, but cooling global demand may counteract that. That said, commodities are the only asset class that has historically had a high beta6 to changes in inflation, and therefore I think it can continue to play an important strategic role in portfolios. I also think precious metals could serve as a hedge against weaker-than-expected growth or higher-than-expected inflation.

 

Risks are higher than normal

As the fourth-quarter sell-off and this year’s rebound illustrate, changes in policy (Fed and trade) are important and can turn sentiment and markets quickly. Markets could face higher volatility in the coming quarters if the Fed pushes back against dovish market expectations or the US targets Europe with trade restrictions. Conversely, if the Fed seems more likely to cut rates or halt its balance-sheet runoff policy sooner than expected, or the US administration eases off its hardline trade tactics, risk assets could outperform my expectations.

An economic surprise to the upside, while not my base case, could be a risk to my conservative outlook. As discussed, China could reaccelerate, the US could respond favorably to easier Fed policy, and Europe could build on nascent signs of a bottom.

Investment Implications 

Credit over equities — I think credit valuations look reasonable, rates are unlikely to rise, and credit could withstand slower growth better than equities.

Defensive sectors and factors — In my opinion, consumer staples, telecommunications, and utilities may be hunting ground for stable earnings and cash flow, key characteristics of defensive companies. Factors defined by these characteristics include safety and quality.

EM equities as a potential hedge against better global growth — If growth accelerates in the coming quarters (not my base case), EM equities may perform well. I think EM equity valuations are attractive despite this year’s rally in consumer-oriented sectors such as education, healthcare, and gaming. I also see upside opportunities in India, which has lagged China.

High-quality government bonds — Inflation leads have softened, growth is likely to be slower, and central banks have stepped back from tightening, all of which suggests to me that interest rates aren’t likely to rise much. I think this makes a case for high-quality government bonds.

Commodities as a potentially dual hedge — While commodities are currently less attractive over my 6–12 month horizon, I still think they have a strategic role to play as a potential inflation hedge. Further, precious metals may be a hedge against a stagflationary outcome.

Idiosyncratic stories — I believe seeking out idiosyncratic stories that rely less on a rising tide of strong global growth and easy monetary conditions may offer downside mitigation.



1 Source: Bloomberg, December 31, 2018
2 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement. 
JP Morgan GBI Emerging Markets Global Diversified Index is a comprehensive global, local emerging-markets index, and consists of liquid, fixed-rate, domestic-currency government bonds. 
MSCI Emerging Markets Index is a free float-adjusted market capitalization-weighted index that is designed to measure equity market performance in the global emerging markets. 
M1 is the money supply that includes physical currency and coin, demand deposits, travelers checks, other checkable deposits and negotiable order of withdrawal (NOW) accounts. 
6 Beta is a measure of risk that indicates the price sensitivity of a security or a portfolio relative to a specified market index.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. • Loans can be difficult to value and highly illiquid; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Risk assets have a significant degree of price volatility.

The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

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