Change is from previous quarter. Views expressed have a 6−12 month horizon and are those of the authors. Views are as of June 2019, are based on available information, and are subject to change without 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.
I think trying to predict the next episode of the trade drama, which has dominated market sentiment so far this year, is futile. Instead, I posit that tensions between the US and China will be a lingering headwind regardless of any near-term developments, and I anchor my outlook to my view of the global economy, monetary policy, and valuations. Specifically, I expect shrinking business investment to contribute to already slowing global growth, and I think the central bank response will ultimately underwhelm markets. Taking all of this into account, I continue to recommend that investors consider positioning their portfolios more defensively than in recent years.
Consistent with late-cycle dynamics, I still favor a quality bias—credit and US Treasuries over equities, and within credit, investment-grade and high-yield bonds over bank loans. I think that spreads1 look attractive versus equity valuations, and that duration2 could add to returns. Longer-maturity US interest rates could decline, but I have a more cautious view on rates in Europe and Japan, which are now negative up to 10 years. Within equities, I prefer the US—while it’s at the center of the trade conflict, its economy is still relatively strong, and the market has tended to outperform when the broader environment has been choppy (Figure 1). I prefer leaning into defensive factors, such as quality and such as quality and safety, which have typically been found in a diverse range of traditional sectors.
US equities have tended to outperform in choppy markets
Percent of quarters the US equity market outperformed and underperformed other markets when those markets experienced negative quarterly returns
Time period: 1999 – 2018. Number of observations: Japan 37 negative quarters, Europe 34 negative quarters, Emerging markets 31 negative quarters. For example, during that time period the Japan market experienced 37 quarters of negative performance out of which the US market outperformed 31 quarters (84%) and underperformed 6 quarters (16%). | Past performance is not a guarantee of future results. | Sources: Bloomberg, Wellington Management
Global fundamentals and the limits on central bank action
I believe the global economy will continue to slow in the coming quarters. Thus, I am not expecting a lift in inflation or interest rates. In fact, central banks in developed and emerging markets have changed their tune and are now generally cutting rates. In addition, quantitative easing (QE) is making a comeback. The European Central Bank (ECB) is likely to restart its program, and the Bank of Japan (BOJ) could be compelled to respond.
However, unlike in recent downturns, I see monetary policy mitigating the downside but not eliminating it. Market skepticism, asset-purchase limitations, and the potential adverse effects of greater negative yields on banks are all issues I see challenging risk assets. I also think the ECB and the BOJ have few effective and easy levers left to pull compared with the Federal Reserve (Fed). Meanwhile, expectations for Fed easing seem too high. Market consensus is for approximately four .25 percent cuts over the next 12 months, in sharp contrast to the Fed’s projections (Figure 2). At the same time, the market is pricing in slightly higher 10-year yields one year out.
The Fed may struggle to deliver what markets expect
Market and Federal Reserve expectations for Fed funds rate at end of each year (%)
As of June 19, 2019 | Market and Federal Reserve expectations for Fed funds rate at end of each year. | Actual results may vary, perhaps signiﬁcantly, from the forecasts presented. | Sources: Federal Reserve, Bloomberg, Wellington Management
Credit is more appealing than equities
I find credit relatively attractive because I think rates may fall, valuations look more attractive than US equities, and credit could outperform equities during a slowdown. I remain moderately bullish on US investment-grade credit because it provides duration and the potential for spreads to compress from above-median levels. I am monitoring leverage in this space, which admittedly has risen, but I am comforted that companies are still generating ample free cash flow and should be able to service their debts.
I am also moderately bullish on US high yield because it tends to be more closely tied to the US economy, which seems better positioned than other developed economies, and spreads are near median, giving them at least some room to narrow. High yield has developed into a more diversified sector with improved average credit quality and is now a permanent source of funding for many companies.
I remain neutral on bank loans as short-term rates may fall and reduce demand for floating-rate instruments. I have not lowered my view on bank loans because they provide steady income and have historically been a low-beta3 investment. I also remain neutral on emerging market debt. The sector offers long duration and may provide compelling opportunities at the country level, but I am concerned that the index is dominated by large countries with structural overhangs, such as Argentina and Turkey.
Country and regional equity fundamentals
I think the US economy will continue to be a relatively solid performer but that its pace of growth will deteriorate as waning fiscal stimulus is overwhelmed by the negative impact of tariffs. Capital expenditures should slow as uncertainty about the US administration’s use of tariffs weighs on business investment. However, US consumers seem resilient and may help the US avoid a sharper correction. In addition, I do expect the Fed to cut rates and provide some support.
With global growth deteriorating and trade risks looming, I would prefer to take equity risk in the lowest-beta markets and, thus, am moderately bullish on US equities. Although they have historically been higher beta, small caps look cheap and may be more insulated from the trade conflict. I also expect quality and safety factors to do well in a slowdown.
European economic growth continues to slow, and, overall, I think leading indicators are pointing to further weakness ahead. Brexit risks will linger throughout the summer and fall and could impact business and market sentiment. Further, I would generally shy away from Europe this late in the cycle, given that it is highly exposed to global trade and turns in the global economic cycle. However, I am maintaining a neutral stance given that some leading indicators may be bottoming (partially aided by a weaker currency), the consumer is still well supported, and valuations are cheap (Figure 3).
Could falling European data be bottoming?
ZEW* Eurozone (EZ) growth expectations and Markit Manufacturing PMI
Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. A reading above 50 signals economic expansion; below 50 signals contraction.*“ZEW” represents Zentrum für Europäische Wirtschaft sforschung, and is a German economic research institute; “Ifo” is Ifo Institute - Leibniz Institute for Economic Research at the University of Munich, which is an economic think tank. | Past performance is not a guarantee of future results. Source: Bloomberg | Chart data: October 2004 – June 2019. X-axis scale December 2004 – September 2019 due to ZEW EZ growth expectations being forwarded 3 months. ZEW EZ growth expectations data is from November 2004 – June 2019 (i.e., ﬁrst data point represents November 2004 and ﬁnal data point represents June 2019. Markit EZ Manufacturing PMI data is from December 2004 – May 2019.
Japanese economic growth, which had held up surprisingly well, is showing signs of fatigue. Consumers are still well positioned thanks to a historically tight labor market, but the business side of the economy has seen deterioration in both hard data and leading indicators. I am concerned that the economy and the stock market are dependent on weakening in the yen, which I find unlikely given the currency’s role as a safe haven in times of stress. What’s more, if the authorities go through with the value-added tax hike scheduled for this fall, the cycle could be further damaged. I think Japan is ripe for stock-picking as few companies are covered by the sell side and corporate governance is improving in some cases, but because I find the market’s beta potential less appealing, I have a moderately bearish view.
Given that emerging markets may struggle to cope with slowing global growth and are the highest beta of the major equity markets, I have lowered my view from moderately bullish to moderately bearish. China’s domestic cycle appears to be slowing, and while I expect some stimulus in response, the government will likely take a measured approach.
However, I do think select countries may be attractive for investors with the necessary risk tolerance at this stage of the economic cycle. In particular, I favor countries with slowing inflation, looser monetary policy, and the long-term potential to benefit from the disruption of supply chains in China, such as India, Indonesia, Malaysia, and Vietnam.
Because inflation is unlikely to rise in a slowing-growth environment, I don’t see a case for adding to commodities. In addition, I think commodity performance is likely to be driven more by demand, which will be muted amid slower growth, even if supply is constrained by geopolitical events. I do, however, see a structural role for commodities as they are the only asset class that has historically had a high beta to changes in inflation. In today’s environment, precious metals may serve as a hedge if the global economy is headed for a hard landing or a larger-scale trade war.
Risks are elevated
Economic and market risks are elevated as a result of the US administration’s cavalier use of tariffs at a time when global growth is slowing. Following tariff threats aimed at forcing Mexico to address immigration issues, it may be hard for businesses to trust that the US won’t threaten or use economically damaging measures in other geopolitical disputes that are outside the economic realm. While not my base case, there is a chance this uncertainty cripples business investment and ultimately infects the job market and consumers. Further, while US consumers remain in solid shape, if the final tranche of tariffs on China’s remaining US$300 billion of US exports goes into effect, it will hurt consumers and my confidence in their ability to weather the economic downturn. Supply-chain disruptions as a result of tariffs or other restrictions could also cripple some companies’ profits and create undue corporate stress. Certain upside risks could affect my views—if monetary policy is more aggressive than the market expects, for example, or if a breakthrough on trade substantially relieves tensions.
Credit over equities — I think credit valuations look relatively attractive versus equities, US rates may fall, and credit could outperform equities in a slower-growth environment while providing some income.
Defensive factors and sectors — Consumer staples, healthcare, telecommunications, and utilities may offer opportunities for stable earnings and cash flow—defining characteristics of the safety and quality factors I favor.
High-quality government bonds — Inflation is unlikely to rise, growth is slowing, and central banks are moving toward easier policy. I think longer-maturity US interest rates in particular look attractive.
Precious metals for downside mitigation — Precious metals may be a good disaster hedge if trade tensions escalate and the global slowdown intensifies.
1 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.
2 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.
3 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. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets. • A focus on investments in particular sectors, geographic regions or countries may result in increases volatility and risk of loss if adverse developments occur. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • US Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest. • Investments in high-yield (junk) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Loans can be difficult to value and less liquid than other types of debt instrument; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. Commodity investments are subject to additional risks.• Diversification does not ensure a profit or protect against a loss in a declining market.
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.