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Multi Asset Perspectives: Too early to re-enter

23 May 2019

This month, the asset allocation committee investment outlook discussion took place against a more challenging backdrop of renewed trade tensions and decelerating global earnings growth. The committee’s key conclusion is that fundamental support for global equities (and credit) is waning. We believe that a defensive stance remains warranted and it is premature to re-engage in risk assets.

Bullish support has faded

By mid-Q1 2019 the asset allocation committee had concluded that this year’s equity market recovery was unlikely to continue apace, even if the policy and macroeconomic backdrop remained benign. As we wrote in March, decelerating earnings growth and rising multiples would eventually stall the market’s advance. A pause, even a pullback, seemed likely.

The catalyst for reversal arrived in the week commencing 6 May with the breakdown of negotiations between the US and China to end their trade dispute. Investors were then unnerved by a tit-for-tat escalation of tariffs between the two countries.

The timing could not have been worse, coming as it did at the end of a supportive US first quarter earnings season and during a lull in key macroeconomic data. Moreover, investors have been too quick to count on the US Federal Reserve (Fed) and other central banks for relief. We believe it will take a larger erosion of asset prices, confidence and growth outcomes for central bankers to validate market expectations for Fed easing this year. Policy puts, if they exist, have strikes well below current market levels.

Chart 1: Fading US earnings growth

Source: Bloomberg at 14/05/2019

Past performance is not an indicator of future performance and current or future trends

Rising trade tensions arrived just as earnings momentum is fading. The year-on-year change in US S&P 500 earnings growth has slowed to just 1% (Chart 1). Given difficult comparisons to last year, an earnings recession over the next two quarters looms as a key risk. Reflecting that possibility, investor appetite for earnings and equity risk has evaporated (Chart 2).


Chart 2: Investors less willing to pay for earnings and price volatility

Source: Bloomberg at 14/05/2019

Past performance is not an indicator of future performance and current or future trends

It is also worth underscoring a point we have made before – the slowdown in global growth momentum in 2018 was largely a result of political and policy uncertainty, not conventional sources of economics weakness (such as monetary or fiscal tightening) or an energy supply shock. Removing those sources of uncertainty – the Fed’s pause, the ECB’s re-introduction of TLTRO (Targeted Longer-Term Refinancing Operations), the avoidance of a hard Brexit and hopes for a US-China trade deal – not only lifted markets, it also underpinned expectations for improved global growth.

The return of protectionism casts anew a shadow over the global growth outlook. Central bankers are not yet prepared to ease. Hard Brexit may have been postponed, but Brexit uncertainty will linger into the autumn. China stimulus is genuine and welcome, but once again China economists are trimming growth forecasts to account for tariff impacts.

Implications for Asset Allocation

Global equities (on a MSCI World basis) are down 4.5% from their recent highs, only a quarter of their 18% plunge of late last year. TINA – there is no alternative to equities – will not be compelling if the market round-trips to its 2018 lows. US dollar investors have a cash yield of 2.2% as a worthy alternative. Ten-year treasuries or even bunds, despite low yields, have generated strong positive returns year-to-date. In short, without supportive news, equities are vulnerable.

Owing to the absent news of a credible trade deal between the US and China, the asset allocation committee feels caution remains appropriate. In strategies with drawdown minimisation or target return objectives, we have endeavoured to neutralise equity directional risk.

Where we hold equities, we prefer allocations to companies, sectors and styles most likely to deliver resilient earnings. Our preferred factors are quality and minimum volatility. We continue to underweight value and cyclicals. We have a preference for companies with high and stable profit margins versus those with low and variable margins.

In fixed income, our preference remains for shorter duration specialty credit, including non-agency mortgage-backed securities and insurance linked bonds, both of which are weakly correlated to bond or equity market direction. Lastly, among alternatives, we retain a preference for diversified relative value positions, including target return strategies.

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.