In the latest instalment of our quarterly series, our five-strong asset allocation experts study investors’ worries ‒ and their own.
Fears of recession are rising steadily in the investment community. Fortunately, central bankers are not sitting on their hands waiting for recession to happen: since the beginning of the year they have collectively transformed the outlook for interest rates. Equity markets have responded with double-digit gains since the low point just before Christmas last year.
Earlier concerns about interest rate rises have now evaporated. There are even suggestions the Federal Reserve, the US central bank, might cut rates next year. That prospect ought to please equity investors, as well as president Donald Trump, who fights for re-election in 18 months’ time.
Lower forecasts on US equities
Schroders’ Keith Wade is one of those who believes rate cuts will be needed next year to prevent the US economy stagnating. He has just lowered his forecast for US growth next year to a measly 1.6% compared with 2.4% for this year. It is a scenario that shortens the odds of recession, he fears.
“Lower growth squeezes company profit margins, as higher wage costs cannot easily be passed on to consumers,” he explains. “That puts the squeeze on cash flows and starts to affect investment and job recruitment. These are the mechanisms to get you to a recession.”
Another warning sign has come from government bond markets, where returns on longer-term debt are now lower than for short-term borrowing: the so-called yield curve inversion. In the past this has often signalled a recession.
But it is not a precise tool for prediction of stockmarket trends. As Monique Wong at Coutts points out: “In the initial stages of an inversion it has been a predictor of positive equity market performance.” Similarly, Richard Dunbar at Aberdeen Standard Investments recalls how in 1996 when the yield curve inverted, “the recession it predicted did not happen for another four years”.
Still cautious on outlook
Having seen a useful recovery in equity markets in the first quarter, our panel of asset allocators remains cautious about the outlook. Mostly they are still modestly overweight in equities, but at the same time they are edging up exposure to bonds, particularly corporate bonds and other forms of corporate credit, to provide some protection should equities relapse again as they did in the final quarter of last year.
A measure of the increasing caution is the decision of three panel members to raise their scores on global corporate credit. Wade has jacked up his score from 3 to 7, and Chris Wyllie of Connor Broadley is also now on 7. Wade explains: “With corporate bonds and other forms of corporate credit, you are not relying so much on the earnings growth of the company as you are with equities.”
Wyllie much prefers corporate bonds to government bonds. “Last year UK government bonds were one of the few sectors with a positive return, so it would have been a good idea to have had some,” he admits. “But you have to realise what we are trying to achieve: to build portfolios that are going to beat inflation – and bonds delivering a yield below inflation don’t belong in those portfolios. You are just paying too much in terms of lost returns.”
He seeks solace instead in high-yield corporate bonds and other forms of fixed term corporate credit, but is avoiding investment grade bonds. “You can achieve a total return of 7% to 8% in the high-yield area,” he says.
Perhaps the most remarkable feature of this review is the increasing support for UK equities, now the most favoured sector with an average score of 6.4. That may astonish some investors, given the political turmoil and economic uncertainty created by Brexit.
Opportunities in a crisis
“This is our big contrarian position,” says Wong. “Our central scenario has been that there will be an orderly Brexit with a deal, but we think we have been prepared as much as we could be for a disorderly Brexit.”
She keeps her UK equities score at 8 and has switched her investment emphasis towards domestic companies, where performance has lagged UK-quoted international companies by about 30% since the referendum.
“I am of the belief that the biggest market opportunities happen when you have a crisis,” she says.
“You identify good fundamental value in a share and you hold your nerve.” Her optimistic view has plenty of support. Wade, Wyllie and Rob Burdett at BMO Global have all raised their scores. Only Dunbar is not now overweight, and even he admits UK equities are “coming to a point where they are increasingly good value.”
Burdett notes how the UK market kept pace with global equities in the opening months despite its general neglect by global investors. “I think valuation support is enough for us despite all the uncertainty over Brexit,” he says.
Though underweight in equities overall, Wyllie has raised his score for the UK from 5 to 6. “The UK has been the best major market for performance this year,” he says. But he points out that even a resolution of the Brexit crisis will not end the uncertainty. “We still have to agree a trade relationship with Europe.”
Muted enthusiasm for Europe
In contrast, enthusiasm for European equities is muted. Only Wyllie is overweight – having pushed up his score from 4 to 6. “It is not that we love European equities to death, it is just that I expect European equities to outperform US equities if the world economy shows signs of a recovery in growth momentum.”
But Wade has taken the opposite line and lowered his score from 5 to 4. He pinpoints the failure of domestic demand in Germany to offset the effect on exports of the slowdown in China. Wong is staying neutral: “If China did recover we would probably upgrade our score on Europe. We are waiting for more evidence of this happening.”
As always, the US remains the crucial driver of global equities. The recovery there since mid-December has been impressive, with the S&P 500 lately trading at not far short of all-time peaks. Now the panel members are wondering whether other markets that are not so highly rated will outperform the US for the rest of this year.
There is a clear division of view within the panel on US shares. Burdett and Wyllie remain underweight, while Dunbar has now gone overweight alongside Wong and Wade.
“My personal view on the global outlook is more pessimistic than most,” says Burdett. “It is a challenging time to make asset allocations so I am raising my score for cash to 9. Valuations, particularly in the US are stretched, so I am keeping my score there at 4.” He fears we might already have seen the best of the US performance this year.
Wyllie also scores a 4 for the US. He says: “Before last year’s correction we became more and more uncomfortable with valuations in the States. Now we are knocking on the door of that same territory of discomfort.”
Wong is much more positive. “We have already had the benefit of Trump’s trillion-dollar tax cuts and I would not put it past him to find more ways to juice up the US economy.”
She points out that although markets have recouped a lot of the losses of the final quarter of last year, “I do not get the sense that investors have really participated in this bounce. It does not feel like people are overly invested in the market at this level.”
US recession threat priced out
Dunbar has raised his US score from 5 to 6. “We are in the third mid-cycle slowdown in a long period of expansion – the longest in the US since the war,” he says. “Our expectation is that there will be some sort of pick-up in growth in the second half of the year. We feel the immediate threat of a recession in the US has been priced out by the markets, but the prospect of a recovery in growth has not been priced in.”
There are mixed signals from the panel too on emerging markets, but nobody is underweight. China holds the key to the sector in its increasing influence on the global economy. Keith Wade is confident of a settlement of the trade dispute with the US, but less sure about China’s willingness to provide further stimulus to the economy. “I think the markets might be disappointed by the outcome. The Chinese are trying to reduce the amount of debt, not increase it,” he says. “So we are lowering our score from 7 to 6.” Dunbar is following suit on China and has instead decided to add to his exposure to the US equity market.
In contrast, Wyllie is finally ending his underweight position in the sector, raising his score from 3 to 5. “I am not wildly enthusiastic about the sector, but you can find better valuations there than in the US.”
Burdett is the most positive of all – raising his score from 7 to 8. “We are thinking the dollar may have peaked, which certainly helps the attractions of the sector – it is already one of the cheap areas for equities. You need to be in emerging markets for the medium term.”
The property sector has proved an oasis of stability through the volatile period of the past few months. When equities cracked in the autumn it had little effect on commercial property values in the UK. The panel’s scores show only one small change and the sector’s defensive and yield attractions remain intact.
Going for gold
In the commodities sector, Wyllie is buying gold because interest rates are staying low, but Dunbar thinks the oil price recovery may have almost run its course. “The benchmark Brent crude is up more than 30% this year,” he says. “I am tempted to cut my score, but will hold it there for the time being.”
Three of the panel lowered their scores for the sector in February, and now Burdett is cutting his score again, this time on a fairly gloomy view of global prospects. “Momentum in key areas of the global economy has faded,” he says. “Commodities react to that.”
Rob Burdett is co-head of multi-manager at BMO Global AM. He leads research teams for UK, Japan and Europe. BMO has £187 billion under management.
Chris Wyllie is chief investment officer at Connor Broadley, a financial planning and investment management firm with £400 million under management.
Richard Dunbar is deputy head of global strategy at Aberdeen Standard Investments, which has some £610 billion under management.
Keith Wade is chief economist and strategist at Schroders. The asset management company has £400 billion under management.
Monique Wong is a multi-asset investment manager at Coutts, the private arm of RBS, which has some £17 billion of assets under management.
Scorecard: better all round
Notes: The scorecard is a snapshot of views for the second quarter of 2019. How the panellists’ views have changed since the first quarter of 2019: red circle = less positive, black circle = no change, green circle = more positive. Key to scorecard: EM equities = emerging market equities. 1 = poor, 5 = neutral and 9 = excellent.
Japan: softer growth outlook hurts equities
Patience is beginning to wear thin over Japanese equities. The Nikkei 225 index has recovered since the low point on New Year’s Eve, but its level is now not much higher than it was four years ago. In our February issue it was comfortably our panel’s most favoured sector with an average score of 6.6. All were overweight except Keith Wade, with Rob Burdett the most bullish on a score of 9.
Now Burdett is re-assessing the situation by cutting his score back to 7. Three other panel members are also following suit. Monique Wong is down from 7 to 5. Burdett warns this month’s results season will see the leading exporters making cautious statements. “It is hard to see a strong rally in Japan in the next three months,” he says. “The longer-term case for Japan remains optimistic, but it is underperforming because of things not happening in other parts of the world.”
He refers, of course, to the US/China trade dispute and the slowdown in Chinese growth numbers, as well as to slower demand in Japan’s major export markets elsewhere.
“Japan is very leveraged to the economic cycle, and given where we are in that cycle we have decided to reduce our allocation,” says Monique Wong. “We like Japan fundamentally, but tactically we have decided to pull back.”
Chris Wyllie admits Connor Broadley still has 7.5% of its growth portfolios in Japanese equities but is lowering his score to neutral.
“Japan was a disappointment to us last year, so we have cut back to raise our exposure in Europe,” he says. “ Normally when everything else is selling off, the yen is supported. But last autumn the yen did not go up. That undermined the case for Japan.