During the first quarter of 2019 global equity markets recovered well, accompanied by sharp declines in bond yields. Central banks played a key role. The US Federal Reserve’s (Fed) decision to pause in January, followed by the European Central Bank’s easing in March, calmed equity investor concerns about weak growth and stoked demand for bonds.
By quarter end, however, investors had begun to ask how much longer stocks and bonds could rally together. That question was also central to the asset allocation committee’s deliberations.
Contrary to conventional wisdom, declining bond yields do not always boost equity valuations. Eventually, weaker growth implied by falling bond yields erodes earnings, so equity prices drop. Weaker earnings also make stocks riskier, leading to equity de-rating.
The determining factor is growth. If economic activity worsens, the bond market will prevail. Recovery, on the other hand, undermines fixed income markets and benefits equities.
The committee believes the bond market will give way, because growth is more likely to recover than stagnate this year.
To understand why, it is important to consider why the world economy stumbled late last year. Typically, slowdowns occur because of one or more of the following outcomes: 1) monetary or fiscal policy is tightened; 2) credit growth slows; 3) inventories rise; or 4) oil prices surge.
It is difficult to fully explain the recent ‘soft patch’ on these factors alone. Despite a series of Fed rate hikes last year, real interest rates in the US were never particularly restrictive. Inventories and oil prices were well behaved. Fiscal policy eased significantly in the US and was not tightened elsewhere. The sole policy restraint was China’s credit tightening.
To be sure, US fiscal stimulus is now fading. However, financial conditions have eased considerably in early 2019. China has also reversed course, deploying credit, fiscal, infrastructure and regulatory policies to boost growth.
The key factor for the world economy in 2019, however, will be confidence. Last year ‘animal spirits’ were dented by fears of trade wars and ‘hard Brexit’. With China and the US nearing a trade deal and as the odds of a ‘no deal Brexit’ recede, confidence is likely to improve.
As a result, we believe bond markets have misjudged the likely 2019 growth outcome. More benign policy, financial and political conditions ought to support a pick up in global growth this year.
The preceding discussion hints at a straightforward asset allocation conclusion: Long equities, short bonds.
Yet matters are rarely so simple. True, shorting US Treasuries and, especially, German Bunds is sensible, in our view. A trickier decision regarding equity allocation is required.
That is because US earnings growth is likely to slow sharply this year, unaccompanied by offsetting earnings acceleration elsewhere. This scenario is probable even if, as we expect, global growth modestly rebounds.
Here’s why. After a stellar 2018, base effects will be challenging for US earnings. Rising labour costs and higher capital expenditures relative to sales will erode margins and asset turnover. US profit share in GDP, a broad approximation for operating leverage, is already falling. Finally, as the economy reaches full employment, the US is no longer capable of above-trend growth.
Investors will therefore be confronted with sluggish earnings growth even as fears of global recession fade. How should they respond?
The members of the committee opt for equity allocations to companies with reliable earnings and solid business models. We favour ‘Quality’ and ‘Minimum Volatility’ factors, as well as companies with high and stable margins versus those with low and variable margins. We also prefer secular growth stories, for example in information technology or Japan. We are sceptical that ‘Value’, financials or even cyclical companies can deliver sustained outperformance.
For diversification purposes we prefer specialty credit, such as mortgage-backed securities or insurance-linked bonds, as well as target return and alternative risk premium strategies. We believe they can generate adequate returns that are weakly correlated to broader moves in stocks and bonds, and will therefore enhance portfolio risk-adjusted performance.