The de-escalation of trade frictions around the G-20 summit at the end of June underpinned a rotation-led recovery of risk assets. Over the past few weeks, equity market leadership has shifted to unexpected quarters – value, small capitalisation, basic materials and even financial shares have led the way higher.
At first glance, that is understandable. Those parts of the market had lagged – in some cases for years – in-favour styles and sectors such as growth, quality or information technology. Receding trade tensions, supportive monetary policy signals and economic resilience also tend to benefit riskier subsets of the market.
Yet the recovery of global equity markets has not been supported by positive earnings revisions, which calls into question its sustainability. That is particularly true for the broad S&P 500 index, which trades on a forward P/E (19.5) above its long-term average and now faces consecutive quarters of negative earnings growth (year-on-year basis). Forward estimates for 2020 are also probably too high, suggesting downward analyst revisions to come.
Absent a significant re-acceleration of global growth, therefore, a rally led by more cyclically sensitive sectors and styles is unlikely to carry on for much longer, in our view.
Yet in a world of over USD 12 trillion in negative-yielding fixed income securities, the concept of TINA – ‘there is no alternative’ – remains a powerful inducement for equity market demand. For dollar-based investors cash also has appeal, though with the US dollar looking toppy in foreign exchange markets, investors elsewhere may not be as persuaded.
Beyond TINA, risk assets have also benefited from signs that the US Federal Reserve and European Central Bank are prepared to ease as an insurance step against downside risks to growth and inflation. That policy shift has increased the value of the ‘central bank put option’ for equity investors. And even if global growth proves to be resilient, the put option will not lose much value, given that below-target inflation enables central bankers to retain their easing bias for longer.
In short, the global equity market backdrop reflects a tug-of-war between negative US earnings momentum, unattractive US valuations and a lack of confidence in stronger global growth versus the combination of few attractive alternatives, supportive monetary policies and signs that the global expansion is not rolling over.
Against this uneven backdrop and given the unpredictable nature of geopolitics, the asset allocation committee is sceptical that the second half of 2019 will deliver another two quarters of strong returns across global equity and fixed income markets. We feel that bond markets can only rally if recession and/or powerful dis-inflation fears arise, which would surely undermine the earnings foundation for equities. Even if the expansion continues, we believe demanding US valuations and poor global earnings momentum will constrain broad equity market gains.
As the contribution from directional moves in major asset classes deteriorates, investors must become more selective within asset classes. That was our primary investment conclusion in June, and remains intact as the second half of 2019 gets underway.
Our favoured positions within equities remain in areas where earnings resilience and visibility are greatest. For eligible portfolios, that includes quality, minimum volatility, baskets of high and stable margin companies, and small-/mid-cap Japan. Over time, we see opportunity in ESG (Environmental, Social and Governance) allocations (with correspondence to quality style). Even if some of these choices are among the more expensive subsets of the global equity market, we believe that in a world of scarcer earnings growth, investors will seek out companies where industry tailwinds are favourable and where firms enjoy market dominance as well as strong financial health and solid governance.
Within fixed income, we advocate a similar degree of selectivity, with a focus on carry weakly correlated to directional moves in bonds. In select portfolios we prefer short-duration US mortgage-backed securities, inflation-linked debt and local currency emerging market debt (which benefits from stable-to-weaker US dollar).
Finally, we reiterate the importance of diversification and capital preservation. We believe cash is appropriate to buffer drawdowns. Portfolios of non-directional returns, including alternative risk premia and target return strategies, remain viable vehicles for generating uncorrelated returns.