Global Asset Allocation Views 3Q 2019Contributor John Bilton
- The global economy has slowed, and trade disputes are raising the downside risks to our forecast for slightly subtrend growth. That said, while remaining wary of the signals coming from the bond market, we don’t see the trade shock as truly recessionary for the U.S.
- We retain our mild underweight to stocks and prefer to take risk in carry assets like credit, while remaining conscious of the liquidity risks. Easier policy may support equity valuations at the margin, but the environment remains late-cycle and we don’t see a strong upside to earnings. Reflecting valuations, we downgrade duration from overweight to neutral.
- We maintain our preference for U.S. stocks over European ones but have dialed down our preference for emerging market stocks, where we see a weak earnings outlook, with downside risks stemming from the trade concerns. U.S. Treasuries remain our favorite bond market, and we upgrade UK Gilts, noting that the risk of a hard Brexit is rising.
SO FAR, 2019 HAS BEEN A YEAR OF SUPERLATIVES. The strongest January equity rally since 1987, the lowest weekly U.S. jobless claims since 1969, the lowest German Bund yield ever and, if we make it unscathed to the end of June, the longest U.S. economic expansion on record. Less constructively, we have the weakest eurozone manufacturing data since the sovereign debt crisis, the flattest U.S. yield curve since the global financial crisis (GFC) and tariffs at their highest level in half a century. Smoot-Hawley it isn’t (at least not yet), but the trade dispute is having a tangible impact on asset markets and the global economic outlook.
Our base case remains that global growth will be positive but unspectacular and that a recession is unlikely over the next 12 months. However, our hopes of a decent second-half rebound in activity – particularly in trade and capex – are fading, and global growth is on track to come in a little below trend for the year as a whole. Recession risks are certainly higher than they were at the start of the year, as a cursory glance at the inverted U.S. yield curve will suggest. But with labor markets robust and household balance sheets strong – on the basis of economic data, at least – risk of contraction over the near term is relatively contained. Further out, however, risks may be more negatively skewed.
The trade dispute is the most eye-catching of these risks and would pose a clear threat to the global economic outlook were it to escalate. The risk of a negative growth shock is among the reasons for the Federal Reserve’s (Fed’s) increasingly dovish tone for U.S. rates. A less well telegraphed but equally valid reason for the Fed’s renewed dovishness is the weakness of inflation data this year. Certainly, the shift in rate expectations has been profound, and markets are now pricing the fastest pace of rate cuts in more than 30 years, absenting the GFC. This is all the more notable given that just six months ago the market was still pricing rate hikes, and the Fed’s dovish reset coincided with a U.S. first-quarter GDP print that was the strongest in four years.
While it is clear that the outlook for policy has eased meaningfully, rates themselves have not actually moved yet. In our view, the market might be overstating the pace of rate cuts. If inflation remains muted, there is clearly capacity for a couple of “insurance” cuts, but the notion that the Fed may cut aggressively in the absence of a further downgrade to the growth outlook might be wide of the mark. Either way, we do not see that easier policy is an unalloyed positive for risk assets; while it shrinks the denominator in present value calculations, it does little for the numerator – earnings – which remain hostage to sluggish levels of global industrial activity.
For now, the resilience of the equity market may well be emboldening the Trump administration to ratchet up trade rhetoric, but this is surely a drag on corporate confidence and earnings. Equity returns and bond yields are likely capped to the upside as a result, while to the downside easy policy, and the likelihood that trade rhetoric would soften if stocks fell sharply, provide a floor to equities. Even if a deal on trade is forthcoming, it is unlikely to be comprehensive and even less likely to address some of the strategic differences between Washington and Beijing that have recently been laid bare.
Our asset allocation reflects this cautious tone. We keep our small underweight (UW) to stocks, supported by our quant models and reflecting the view that equities are near the upper end of their trading range. At the same time, we acknowledge that growth remains positive and policy easy, which together support our overweight (OW) to credit. Nevertheless, we are mindful that as the cycle matures the liquidity risk in credit may eventually overwhelm the attractive level of carry.
The drop in bond yields over the second quarter prompts a downgrade on duration from OW to neutral. With just under a quarter of global government bonds yielding less than zero, we believe that, absenting a further downgrade to global growth, yields are at the lower end of their fair value range. Regionally, we still favor the U.S. in both equities and bonds but note that it is U.S. large cap stocks specifically where we are moderately upbeat on earnings. Europe remains a less favored region, and our outlook on emerging market (EM) assets is cooling again as trade uncertainty creates a persistent headwind for growth in those economies.
Overall, this reflects a guarded macro outlook, increased tail risks and a scarcity of compelling relative value opportunities, barring our preference for U.S. assets. Over the next few months, it is likely that the pendulum swings between hopes of growth rebounding and rates falling, and fears of intensified trade tension. As this unfolds, opportunities will present themselves, but with geopolitics driving the macro agenda, allocation may be as much about timing as it is about fundamentals.
Key themes and their implications
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