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Multi Asset Perspectives: Fixed income fantasies

19 June 2019

The asset allocation committee met to discuss the investment outlook as the second quarter draws to a close. Here are their key conclusions.

Circumspect thinking

After a shallow pullback in May, risk assets have recovered, making up most of the ground they lost. Signs of resilient growth, the avoidance of a second-front trade war with Mexico and expectations for supportive monetary policy have all underpinned the improved market tone. In the US, the combination of firmer Q2 growth, as evidenced in June by stronger-than-expected retail sales and stabilising production, alongside lower-than-expected inflation (and falling long-term inflation expectations) has permitted investors to fantasise about a goldilocks scenario of trend growth, full employment, high returns on capital and easier monetary policy.

Yet fantasy is rarely the foundation of sound investment strategy. Increasingly, the committee is concerned that wishful thinking will result in disappointment.

Where we believe the collective market psychology is apt to be correct is with respect to the resilience of economic activity. In our view, the most probable outcome remains one of steady, trend-like global growth accompanied by full employment in advanced economies. As we have noted before, the underpinnings of US, UK, European and Japanese growth reside in rising household income courtesy of job gains and modest real wage increases, alongside high corporate profits. Income-based expenditure tends to be quite resilient to shocks.

Expectations for corporate earnings growth rates, however, are more circumspect. Rising costs, weak productivity and the need for more capital spending are eroding operating margins and asset turnover. Base effects, particularly in the US, are challenging. For the upcoming reporting season, S&P 500 earnings growth is running below 2% year-on-year. Should revenues soften, even modestly, an outright US earnings decline may well ensue. In our view, over the next few quarters, a US earnings recession is considerably more likely than a US economic recession.

Which brings us to the most egregious fantasy, which resides in fixed income markets. Current market pricing discounts roughly three quarter-point Federal Reserve (Fed) rate cuts over the next year, with the first coming in Q3 2019. We believe that is a dubious degree of investor confidence for the following reasons:

First, for the market to discount with near-certainty that the Fed will cut rates significantly the economy must already be subject to considerable restraint. Yet neither real interest rates nor fiscal policy are restrictive. Trade war uncertainty has been high, but experience suggests the impacts of uncertainty can be overstated. Since 2009 the global expansion has shrugged off a variety political shocks.

Second, the US forward curve embeds curious assumptions about the Taylor Rule [which describes the Fed’s interest rate decisions]. By forecasting rate cuts, the market must believe one or more of the following:

  • The coefficient on the output gap has declined sharply;
  • The coefficient on the inflation gap has risen significantly;
  • The observed unemployment rate is wrong;
  • The current Fed funds rate is restrictive.

There is only one problem: The Fed has not endorsed any of those beliefs in speeches or statements.

In short, either the bond market has a markedly different outlook on growth from the Fed and the equity market, or it believes the Fed’s reaction function has fundamentally changed. The evidence for either hypothesis is not, in our view, compelling.

Implications for asset allocation

It will not come as a surprise, therefore, that long duration is our least favoured position. Yet the committee shares the view that actively shorting bonds today may not be warranted. Absent a catalyst to reverse market sentiment, prevailing pricing can endure.

In that regard, the upcoming FOMC announcement will be scrutinised to see how much the Fed pushes back on prevailing market beliefs. The answer will probably be not much, in our view. Given the latitude offered by below-target inflation, the Fed can be patient and need not tip its hand. In all probability, the Fed will perceive little to be gained from taking on the bond market just yet.

Elsewhere, the asset allocation committee also counsels caution. Low bond yields and flat or inverted yield curves take the starch out of financials and value stocks. That has implications for overall equity returns, as a broad market advance cannot rely exclusively on narrow leadership from tech, growth and quality.

Hence, selective exposure remains our mantra. Our favoured positions within equities remain in areas where earnings resilience and visibility are greatest – quality, minimum volatility, baskets of high and stable margin companies, and Japan.

We also reiterate the importance of diversification and capital preservation. Cash is appropriate to buffer drawdowns. We remind readers that the primary consequence of ‘Post Peak’ is lower risk-adjusted returns to broad market exposure. Simply being invested is not enough. We believe selective exposure to reliable sources of earnings, accompanied by appropriate diversification, better suits a ‘Post-Peak’ market environment.

Important legal information

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 of current or future trends.