GAM Investments’ Julian Howard outlines his latest multi asset views, discussing why growth and therefore interest rates are likely to remain subdued both in the short and long term and how investors could position accordingly.
The third quarter of 2021 saw the MSCI AC World Equity Index (GBP) gain by circa 3%, making for a year-to-date figure (to 30 September) of circa 16%. The third quarter’s return, while solid enough, was more subdued than recent quarters for a combination of reasons. First, US economic activity started to slow down amid rising cases of the Delta variant of Covid-19 as well as supply shortages caused by a slowly recovering labour market and disruption to imports from Asian markets. Second, emerging market (EM) equities were hit by a perfect storm of disruption. A strengthening US dollar versus its main trading partners continued to exert a tightening effect on emerging economies whose debt and trade receipts have over the years increasingly been denominated by the greenback. In addition, the relentless pursuit of ‘Covid-zero’ policies has caused spot lockdowns that have disrupted factories and indeed entire industrial towns across China and Asia to the point that major US consumer firms have lobbied Asian governments, such as that of Vietnam, to rethink their approach. Finally, and perhaps most significantly, China has been shifting away from a growth-at-all-costs strategy towards one of more balanced – and progressive – economic development. This has taken the form of assertive interventions across a range of sectors including technology and education which have caused many investors to flee the market. These developments offer the fairest explanation of why market returns were more subdued during the quarter but that they remained positive at all probably had more to do with the perceived direction of interest rates. While the US Federal Reserve all but declared that tapering of asset purchases would begin in November, outright interest rates increases remained far off into the future amid the mixed data described above and a slight cooling of the stronger inflation that has characterised the last few months. For this reason, stocks with strong and reliable revenue profiles outperformed those which were either cheaper than the rest of the market or which stood to benefit from a strong cyclical recovery. In other words, growth outperformed value and this was enough for global equities to transcend ongoing questions around the economic outlook.
Chart 1: Global growth indicators reveal a slowdown in activity
Our asset allocation decisions are heavily informed by the equity risk premium (ERP). With an S&P 500 earnings yield of 4.6% and comfortably in excess of the circa 1.5% yield on the 10-year US Treasury, we believe stocks remain well supported and we maintain our overweight position. Within equities, we emphasise the growth style described above, expressed via US equities generally where growth is well represented, but also by our dedicated Nasdaq 100 exchange-traded fund (ETF) exposure and exposure to a growth-orientated active Japanese equities manager. We have for some time now maintained a structural allocation to EM equities and this did not change despite the volatility the asset class experienced during Q3 2021. We have built this exposure via an ESG-screened ETF of the MSCI EM Index as well as an active manager focusing on value firms with strong growth potential. Away from equities, our emphasis is on reliability and defensiveness rather than outsized returns. We do this via a diversified bond strategy that incorporates subordinated financials, mortgage-backed securities, insurance-linked bonds, ultra short-dated investment grade paper and some high-quality government issuance. Alternatives make up a smaller proportion of the capital preservation sleeve and here we have deployed two equity long / short managers whose performance over the quarter picked up after a quieter start to the year. Finally, in tactical asset allocation, we maintained a short US Treasury position to reflect the risk that yields rise amid US recovery and anticipation (misplaced in our view) of higher interest rates. This generally worked, albeit at a slow pace given that said recovery started to falter during the quarter. Finally, we tactically added S&P 500 futures exposure on the market drawdowns seen in late September given our central view that equities still have upside potential.
With the global recovery so uneven and indeed faltering in the US and China, it is worth considering what kind of growth trajectory is realistic over the long term, since this will inform the likely course of interest rates and therefore the appropriate strategic asset allocation and equity composition across portfolios. On this front, we regard the picture as sobering. Even assuming that effective Covid-19 vaccines can be rolled out to the whole world by the end of 2022, a series of rolling growth shocks will still present themselves to policymakers in subsequent years. Inequality has on many measures likely worsened during the pandemic and this will hurt the consumption that economies such as the US, UK and now China rely on, if only for the simple reason that lower income consumers have a higher propensity to spend while those on higher incomes tend to save. The other issue is demographics. Shrinking workforces and growing cohorts of those dependent on them will negatively impact growth in the UK, western Europe, China and Japan. But perhaps most importantly, we believe climate change is likely to present a shock easily in the order of magnitude of the global financial crisis of 2008 or the more recent Covid-19 response. Potential mitigations to these challenges do exist but demand a level of concerted international coordination that appears elusive based on recent experience. In this context, the job of central bankers could well be reduced to providing maximum monetary accommodation on a virtually permanent basis. This in turn should boost the net present values of long duration assets such as growth stocks or long-dated government bonds for the foreseeable future. As tempting as it is to declare that US-dominated global equity indices cannot possibly progress further or that developed market government bond yields cannot sink lower either, this is in fact exactly what could occur in a world facing multiple growth headwinds. This counter-intuitive conclusion may be uncomfortable, but we believe it forms the centrepiece of a pragmatic, evidence-based investment strategy.
Chart 2: Climate change all but guarantees subdued growth…and low interest rates
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.