J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insights.
THIS QUARTER’S THEMES
1. Monetary policy alone may not lift global growth
Uncertainties stemming from trade tensions continue to weigh on global growth momentum, especially corporate investment. Consumer activity is currently tempering the slowdown, but recent data showed consumer sentiment softening. Global central banks are stepping up and cutting rates but this may not be enough: many economies, including the eurozone and Japan, are at their limits of potential easing. Economic reforms, tax cuts and more government spending are needed to support growth. These kinds of changes would require a change in mindsets on fiscal spending and political coordination, both of which can be challenging.
- Global PMIs are approaching the end of 2019 on a weak note.
Protectionist policies weighing on capex
- U.S.-China trade tensions, and the rising specter of protectionist politics exemplified by Brexit, have impeded many companies’ ability to make investment decisions in recent months. This is unlikely to change soon; even as U.S. President Donald Trump postponed some tariffs and China waived others, the threat of a trade war continues. Manufacturing purchasing managers’ indices (PMIs) globally declined through the northern summer but appear to be stabilizing at a low level.
- Consumers continue to be the pillar supporting growth, shoring up a number of key economies around the world aided by low unemployment rates. Consumer strength underpins our view that the global economy will probably avoid a sharp slowdown in the months ahead. However, we are closely watching corporate sentiment, which has been cautious, for signs that caution could tip toward slower hiring and wage inflation.
- U.S. consumers are still supporting the U.S. economy.
Watching for U.S. recessionary signals
- The inversion of the U.S. Treasury yield curve prompted concerns that a recession is on its way. We have previously highlighted that years of quantitative easing have weakened the signaling effect of the curve’s slope. Historically, there has also been a considerable time lag between curve inversion and recession. We should not ignore it, but nor should it be the sole indicator we use.
- U.S. business confidence, new orders and jobs numbers have softened in recent months but are still some distance away from thresholds consistent with recessions. Credit conditions remain accommodative and household balance sheets remain in good health.
- The Fed’s rate cuts have opened the door for other central banks to follow suit.
Some central banks are approaching their limits
- Global central banks have turned decidedly dovish in 2019. Since the start of the year, emerging market central banks have already cut rates 30 times, in many cases unexpectedly. Developed economies’ room for easing is more limited. The European Central Bank adopted a zero interest rate policy (ZIRP) in 2016 and has negative deposit rates. The Bank of Japan has run similar policies in recent years. It is hard to see how these central banks could push rates any lower without hurting banks’ appetites to lend and savers’ purchasing power.
- Officials at the U.S. Federal Reserve (Fed) will likely be persuaded by the strength of the U.S. consumer that a long series of rate cuts is not necessary at this stage. Real interest rates are already negative at the long end of the yield curve, which should keep corporate borrowing costs low. These factors imply that the Fed will be measured when it comes to monetary easing in the months ahead.
- More fiscal stimulus is needed to protect economic growth.
Fiscal boost would need political coordination
- With limited room for monetary stimulus in most major economies, fiscal stimulus is expected to play a crucial role in supporting growth. Falling funding costs are also allowing governments to borrow more cheaply. However, not all governments will approach stimulative policies in the same way.
- We expect China to pick up the pace of government spending, especially in infrastructure, since it already reduced taxes and government fees earlier this year. Beijing has also announced policy reforms designed to boost consumption. In Germany and Japan, governments can borrow at negative interest rates but policymakers will need to review their fiscal discipline principles to inject stimulus into their economies. In the U.S., President Trump strongly favors introducing another fiscal package to boost the economy going into the 2020 election year, but this would likely face considerable resistance in Congress.
2. Finding balance in rough times
Global uncertainty has continued to rise in recent months. The main concerns weighing on markets have not subsided; in some cases, they have worsened. With market volatility from geopolitical issues and growth worries prevailing across asset classes and geographies, we advise caution. Taking a more balanced stance—including defensive moves, through adding income-generating investments—should remain a popular investment theme.
- Income and appreciation combined: Preparing for downturns while remaining invested.
Caution is warranted, but not to extremes
- Volatility is here for the foreseeable future, as both economic and political issues create uncertainty. Investors now face an unappealing market environment that combines low growth, low inflation and low yields.
- Even as uncertainty and risks to growth continue to build, though, investors should aim to remain invested and position themselves for the long run. This may involve being less aggressive in their allocations and cushion market volitility by seeking balance and diversification in their portfolios.
- Aim for a portfolio mix combining capital appreciation with income generation, which can potentially provide some downside protection when the market declines.
- The High Dividend Index has outperformed the broad index.
Take advantage of equity income
- Instead of relying primarily on capital appreciation, an approach that will suffer if growth takes a turn for the worse, consider income generation, which can provide partial relief in a downturn.
- High-dividend equities are a long-term investment theme and an attractive tactic in the current environment. High-dividend defensive stocks may outperform during a stock market slump, while high-dividend cyclicals can bear more of the responsibility if events shift in the opposite direction. Combining both types of dividend stocks will enable an investor to switch stances and maintain portfolio balance.
- A combination of these two types of income-generating equities offers a good risk/return trade-off. Over the last 15 years, the MSCI AC Asia Pacific ex-Japan High Dividend Index has generally outperformed the broad index in total return terms and has a better Sharpe ratio, at 0.64 compared to 0.43 of the broad index.
- Amid low rates, higher yielding securities will remain in focus.
Seek yield but be vigilant
- Bearing in mind the uncertain economic outlook, investors may find that adding less volatile fixed income assets to their portfolios can provide the benefit of diversification against riskier equity exposure. With the U.S. Federal Reserve expected to maintain an easy policy stance, and amid continued low inflation, the hunt for yield in fixed income will go on.
- As rates are likely to remain low, cash deposits are a questionable choice, even with a low growth outlook. Instead, this is a good environment for higher-yielding fixed income, to help generate income. However, investors should be aware that higher yield tends to come with higher risk, so yield should not be the only consideration. It is important to balance attractive opportunities with safer holdings. Investing tactically with the help of active management can help manage risk.
- Asset-backed securities can play several roles that we expect to be helpful under the current scenario. U.S. agency mortgages have historically had a negative correlation to equities, providing diversification. They also feature better yields and lower volatility than U.S. Treasuries, which make them attractive. Non-agency mortgages, another option, will tend to be more driven by the U.S. housing market and consumer dynamics, but we currently do not see many concerns on the horizon here despite a rise in recession risks.
3. Oh, inverted world
The supply of negative-yielding bonds around the world reached a record high last quarter and is broadening beyond the core developed government bond market. Declining inflation expectations are being met by rising expectations that interest rates are on a race to zero and by central banks’ renewed interest in unconventional policies. All these create a challenging environment for those in need of income. Yield chasing will support some asset classes—and there is still yield to be found, for those willing to give up some liquidity. However, investors will need to be mindful and manage the many risks and unintended consequences that come with investing in an inverted yield world.
- The supply of negative yielding bonds has reached record levels.
The race to zero
- The unremitting trade war between China and the U.S. and the rise in other threats to global growth have spurred a dramatic reversal in monetary policy. Numerous central banks in emerging and developed markets have started to cut interest rates and some have suggested they will adopt unconventional measures, if needed, sparking the possibility of a race to zero interest rates.
- Against this backdrop, the supply of negative-yielding bonds has surged. Currently, around one-third of the global government bond market trades with a negative yield and they are appearing in ever more countries. The bonds of several European countries, including Germany, Denmark, Finland and the Netherlands, offer negative yields across their entire curve. Negative yields are not limited to government bonds; the share of the corporate bond market offering less than 0% yield is also on the rise.
- By making money as cheap as possible, central banks hope to spur borrowing and spending to stimulate economic activity. This does happen in the near term, but negative cash rates penalize savers and holders of interest-bearing assets, which may harm the growth outlook in the longer run.
- Meanwhile, the growth in negative-yielding bonds could become self-propagating. Large institutional investors, such as pension funds and insurance companies, are required to hold higher-quality fixed income assets regardless of yield. These buyers may wish to lock in yields before they fall even further, which creates demand and pushes bond yields lower still.
- One consequence may be to drive an international hunt for yield and demand for U.S. Treasuries, which offer a relatively high yield.
- U.S. consumers’ resilience undergirds the market for securitized assets.
- Income and protection together are rare in fixed income market.
- The policy guidance offered up by central banks, particularly the European Central Bank, has been a willingness to cut rates further and resume bond buying programs or other unconventional policy measures. This means that bank deposit rates are likely to fall further, making large cash allocations likely to remain unattractive for some time to come.
- The low interest rate environment also means that investors will remain yield chasers, likely offering support to the extended sectors of the fixed income market and other asset classes where it is possible to earn higher income through an illiquidity premium.
- Corporate credit markets globally offer relatively attractive risk-adjusted returns over government bonds, given current low default rates and a steady pace of deleveraging. However, investors need to carefully consider credit quality and market liquidity.
- The resilience of the U.S. consumer makes the yield pickup available in U.S. asset-backed securities, such as mortgage-backed securities, an attractive proposition. Healthy household balance sheets and low debt-servicing costs are keeping mortgage delinquency rates in check.
- Alternative income streams from real assets are another source of yield that may be less correlated to economic activity and can also provide portfolios with an additional layer of diversification. These types of assets usually involve a trade-off, however, between yield and liquidity.
- Close to USD 17trillion in negative-yielding bonds, and a U.S. yield curve that has at times inverted, suggest that market risks have risen. While a near-term recession may be avoided, investors will have to be active in managing liquidity, default and other market risks as we move further into the late stage of the economic cycle.
4. Navigating geopolitical minefields
Geopolitical uncertainties are casting dark clouds over the global growth outlook, and heightened volatility is making it increasingly challenging for investors to navigate the investment landscape. In times of elevated volatility, investors may want to assume a cautious, defensive stance on risk assets. They may want to take a more diversified approach in their portfolio positioning and to focus more on income. Investors that are less risk-averse may want to consider taking a more active approach using liquid alternatives.
- The U.S.-China trade dispute may have a longer lasting impact.
Geopolitics driving higher volatility
- Recent geopolitical developments are clouding the global growth and investment outlooks. They include continuing U.S.- China trade tensions, the risks of a no-deal Brexit and the Hong Kong protests, to name a few. Elsewhere, developments connected by a common thread of rising populism and anti-globalization are taking hold.
- Geopolitical events generally do not have long-lasting impact on financial markets unless they result in a highly disruptive regime change. However, they often cause significant near-term disturbance and asset volatility as investors grapple with increased uncertainty.
- Further escalation of trade tensions could weigh on U.S. consumers.
Spillovers from U.S.-China trade tensions
- The U.S.-China trade dispute stands out because beyond being a key short-term investor concern, it has the potential to cause longer-term disruption to financial markets.
- The Trump administration’s recent tariff hike to 15% on USD 300billion worth of China imports caused global equity markets to sell off and volatility to rise. Notably, this occurred when the global industrial cycle was in a cyclical downturn. Investors fear that further dislocations in trade and investment will have negative spillover effects on the labor market and affect the U.S. consumer—the backbone of the U.S. economy. The concern is that a weakened consumer could drag the U.S. economy into a recession.
- While Fed rate cuts can help mitigate downside risks to the U.S. economy, they can only do so much to lift domestic growth prospects. With the Fed funds rate now near its effective lower bound, the potential impact of monetary policy on economic activity is more limited.
- A more defensive, income-focused portfolio may buffer against higher volatility.
Tip-toeing through the geopolitical minefield
- Geopolitical uncertainties will likely remain high in the near term as many doubt the U.S. and Chinese governments will reach a resolution on trade. In this environment, investors may want to take a cautious and defensive stance on risk assets. The most obvious call to action is to reduce the beta, or market sensitivity, of their investment portfolios.
- For instance, investors could tilt toward a more income-oriented diversified portfolio, shifting toward a higher allocation to fixed income and high-dividend stocks. Income portfolios have historically outperformed 60/40 stock/bond balanced portfolios in volatile periods because income payouts (in the form of coupons and dividends) help to buffer return performance in times of increased asset volatility.
- Within fixed income, investors may also wish to allocate more toward government bonds and higher-quality corporate bonds, which are typically seen as less volatile instruments compared to high-yield corporate bonds. And within equities, investors may consider higher-quality, secular growth plays that can provide further resilience to the overall investment portfolio.
- Uncorrelated strategies: a source of return in volatile environments.
Avoiding the geopolitical minefield
- Investors that are less risk averse can also consider taking a more actively managed approach, introducing more tactical flexibility into their investment decisions. For example, liquid alternatives, assets that can trade long/short derivatives and other strategies uncorrelated to market beta, can potentially take advantage of volatile environments as opportunities for generating alpha, or excess returns.
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