19 March 2019
Earlier this month the asset allocation committee met to discuss the investment outlook. Investor nerves are once again being tested by poor news. Tactically, we adopted a more cautious approach in mid-February, which we retain. Yet we also conclude that fundamentals are likely to improve, albeit not just yet.
A few weeks ago the asset allocation committee concluded that the equity market surge of early 2019 was unlikely to continue. Given decelerating earnings growth, expanding multiples could not power equities for much longer. A pause or even a pullback seemed likely.
In early March, markets were unsettled by a spate of bad news. China’s February exports and imports fell much more than expected. The European Central Bank (ECB) shocked markets with a sharper-than-expected reduction of its eurozone growth forecasts. The February US employment report also revealed a stunning deceleration of job growth.
Meanwhile, concerns are rising that the anticipated trade agreement between the US and China may not come as soon as hoped. A summit between presidents Xi and Trump at the end of this month appears in jeopardy. At the same time Brexit-related uncertainty is likely to persist.
Many economists now forecast recession by the end of 2020. Bond markets have edged in that direction. Forward curves suggest the Federal Reserve (Fed) is more likely to cut than hike. German 10-year yields are barely positive, having plunged some 50 bps from their 2018 highs. Equity markets are jittery.
But are fundamentals likely to deteriorate that sharply?
We doubt it. The surprise is more likely to be a modest re-acceleration of global growth by year end. It remains premature to position aggressively for that outcome, but that is nevertheless the likely direction of travel.
That is in part because some of the recent data may be revised away. The first quarter is always problematic for Chinese data, given the shifting dates of the lunar New Year holiday. Poor weather and the US government shutdown may have distorted the most recent jobs numbers.
Beyond seasonal vagaries, it is important to answer a simple question: why did global growth slow in 2018? The answer, we believe, suggests a greater likelihood of improvement than markets presently discount.
Cyclical slowdowns are typically precipitated by one or more of the following: 1) a tightening of monetary policy; 2) a tightening of financial conditions; 3) a tightening of fiscal policy; or 4) an energy price shock. Based on 21st century experience, we could also add an investment boom that goes bust.
Looking back on 2018, it is difficult to see any of the above as a significant precursor to the slowdown witnessed. To the extent that some of these factors posed some headwinds last year, we believe they are more likely to become tailwinds by the end of 2019.
Consider monetary policy. Last year the Fed hiked and China slowed credit growth. Yet it is difficult to suggest that the Fed tightened a great deal. US real three-month and 10-year interest rates, which peaked in the third quarter of last year at about 0.5% and 1.5%, respectively, were well below the levels reached prior to previous post-war recessions. Indeed, in equilibrium real interest rates should converge to potential real GDP growth. Today that figure is between 2.0 and 2.5%. Real US rates hardly made it to half that level in 2018, suggesting that Fed was not even restrictive last year.
In China, monetary (credit) policy was tightened from late 2017 through most of last year. However, China is now reversing course. Following last week’s National People’s Congress meeting, credit and fiscal policy are set to ease in an effort to stabilise growth.
For most of 2018 credit, equity and currency market conditions were benign and only tightened in the final quarter of the year after growth had already slowed. Financial conditions did not precipitate the global slowdown. Moreover, this year equity and credit markets have rebounded, accompanied by lower bond yields. If sustained, those moves will also turn headwinds into tailwinds.
Fiscal policy surely cannot be the culprit for last year’s slowdown, given implementation of US tax cuts. In 2019 the US fiscal impulse will fade, but that should only slow the economy toward trend, not push it into recession.
Neither energy prices nor unsustainable investment booms can account for the 2018 deceleration. Last year, energy prices oscillated in relatively narrow ranges. Subdued global residential and non-residential investment has been a hallmark of the past decade. There was no cliff for it to fall off.
So what accounted for the 2018 global growth slowdown? Most probably, therefore, three factors were responsible, of which two are fading. First, the aforementioned tightening of credit policy in China slowed growth in countries cyclically linked to trade and manufacturing, namely European and emerging economies. China is, as noted, now easing, so relief is most likely on the way.
Second, special factors related to automobile production (such as the diesel shock) and transportation hit Europe last year. They are unlikely to repeat in 2019.
Third, uncertainty took its toll on growth, a point emphasised by ECB President Draghi last week. Fears of trade wars, Brexit, populism, Fed tightening and other policy or political risks dampened ‘animal spirits’. Here, too, some reversal is in the making; the Fed, for example, has become ‘patient’ and the ECB has eased.
Trade wars and Brexit have probably been more significant drags on global growth than many economists believe. What matters is not the direct impact of tariffs, but rather how uncertainty corrodes confidence, curbing investment and discretionary spending.
The implication is clear; the outlook for global growth hinges importantly on whether bad outcomes can be credibly avoided.
Credibility is important. A trade deal between the US and China will not boost sentiment and growth much if it can be reversed by tweet. A short-term postponement of Brexit will not remove its Damocles sword hanging over the UK and European economies.
Yet if both challenges can be resolved, the world economy may well find its footing. That is what we are watching for as the catalyst to re-engage more fully in risk assets.
Last month, we trimmed allocations in most higher beta segments of global equity markets. Quality, minimum volatility and high and stable margin versus low and variable margin baskets of stocks remain our preferred equity positions. In some portfolios we have initiated smaller exposures to ‘value’ and to beaten up markets such as Europe, but that is mostly ‘toe dipping’. We continue to shy away from UK equity, fixed income and currency exposures, given the uncertainties surrounding Brexit.
In fixed income, our preference remains for specialty credit, shorter duration exposures and cash. Developed economy government bonds are unappealing. Last month we initiated short duration positions in German 10-year bonds. Despite the recent rally, we are undeterred.
In our long-orientated multi-asset portfolios we maintain low allocations to alternative strategies. However, in our strategies that aim to achieve mid to single-digit volatility with minimal drawdown we are building positions in liquid alternatives, target return strategies and alternative risk premiums, such as credit or commodity roll yields. In such portfolios non-directional positioning acts as a diversifier and as an important component of capital preservation.
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.