The market volatility that struck in the first quarter has persisted into the summer. Now it is joined by a heightened feeling of disconnect in regional economic growth rates, in geopolitics, in global trade, and in the relationships between some market prices and their underlying fundamentals. The Asset Allocation Committee (“AAC” or the “Committee”) maintains that global growth can get back on track and the business cycle can extend into 2019 and beyond but acknowledges that, before this reconnect, the current disconnects are a source of considerable short-term uncertainty. To reflect this, the Committee has become more neutral in its views on relative market risks as it seeks clarity on the path of growth and interest rates into 2019, as well as near-term trade frictions and election risks. The AAC is maintaining exposure to emerging and inflation-sensitive markets, while increasing focus on idiosyncratic opportunities with alternative strategies, and by exploiting some of those disconnects in market pricing.
When U.S. President Donald Trump left the June G7 meeting early, and then rejected its joint communique backing a “rules-based trading system,” he distilled the heightened feeling of disconnect that gripped the second quarter of 2018. Allies and trading partners feel disconnected from one another. European and Japanese Purchasing Managers’ Indices continue to disconnect from the more confident readings out of the U.S., breaking the synchronized global growth of 2017. Emerging economies have disconnected as fragility arose in Argentina and Turkey as the U.S. dollar strengthened, despite the fact that other developing economies continue to demonstrate strong mid-cycle fundamentals. This has all added to the market volatility that resurfaced in February this year—causing some investors to disconnect from their risk exposures.
The AAC understands the turn in sentiment but still thinks it is too early to adopt an outright defensive or risk-averse stance.
Markets need to build trust in the current U.S. administration’s competence on trade. Until they do, the aggressive and unorthodox approach will be a source of volatility. But while the AAC regards the risks as substantial, it is reassured by the clear incentives the main players have to avoid a truly damaging outcome (see “Up for Debate: The First Shots in a Trade War?” below).
We acknowledge the disconnect between economic growth and confidence in the U.S. and elsewhere, but we would also point to the fact that activity in Europe, in particular, has pulled back from unsustainably high levels. The AAC does not see any signs of a structural growth shock and therefore anticipates a gradual reconnect in the regional economic data in the second half of the year.
That has implications for volatility in rates, fixed income and currencies. For more than two years, the biggest market mover has been the U.S. Federal Reserve. Now, however, if our central scenario of a return to smoother global economic growth into 2019 turns out to be correct, the forward path of Fed rates and balance-sheet reduction is as clear as it has been for a very long time. It is time for the European Central Bank (ECB) to take the lead. While it has undertaken to hold interest rates until next summer, as conditions evolve that could add to the uncertainty about how fast it will need to move when it is time to hike.
In that scenario, the U.S. dollar is beginning to look overstretched. This year it has been subject to a battle between the downward pressure of the U.S.’s twin deficit and the upward pressure of the U.S.’s relatively high yields, with the yield differential winning out. Recent risk aversion has pushed it up still higher. In the absence of a serious negative shock, however, the shift of the market’s attention from Fed tightening to ECB tightening could start to bring the dollar back into a narrower trading channel. Should the dollar retreat a little from its current heights, it follows that much of the recent negative sentiment around emerging markets could dissipate (see “Up for Debate: Emerging Markets—Opportunity or Warning?” below).
This remains the AAC’s central expected scenario, but there is no denying that the degree of certainty around that scenario is lower at the end of the second quarter than it was at the end of the first.
“Right now we are waiting for more clarity on U.S. earnings growth for 2019 and a recovery in the economic data out of Europe,” as Joe Amato put it. “We know that the effect of the U.S. tax cuts will likely begin to fade toward the end of the year, and Europe’s data is getting worse in the short term, not better. Reassurance on those issues will enable us to withstand higher interest rates and extend the business cycle. In the meantime, market beta will be the tip of the spear of uncertainty, so we favor exposure but also see the need to manage our risk budget.”
How does this translate into changes to the AAC’s asset class views?
Although we identify some interesting opportunities in short duration credit, as described below, the Committee maintained an underweight view on investment grade fixed income overall. With Treasury rates likely to be rising, it will generally fail to provide diversification when sentiment turns against equity risk.
The view on global equity remains slightly overweight but has turned more neutral overall, as the AAC is more positive on U.S. markets and less positive on non-U.S. markets than it was at the end of the first quarter.
On this occasion, however, our headline asset-class views conceal many nuances. In developed non-U.S. markets, for example, the view on Europe has been downgraded on uncertain fundamentals and full valuations, while the view on Japan has been upgraded to reflect the weaker yen and the evidence that inflationary “Abenomics” is gaining enough traction to offset some of the uncertainty around global trade. We also remain overweight in our view on emerging markets equity, given our outlook for a “reconnect” in global growth and a dollar retrenchment.
Similarly, while the AAC is more neutral on equity, it maintains its overweight view on private equity and now views both hedge fund styles, low-volatility and directional, as an overweight.
In private markets we acknowledge that there are aggressively leveraged and valued deals being transacted, but our view reflects a preference for more opportunistic, niche strategies focused on high-quality and growth investments that are not easily replicated in the public markets. It is also worth reiterating that the view applies to commitments made today that will find their way into investments over the coming two to three years: vintages raised near market peaks have tended to outperform because they were investing as the euphoria cooled off.
In hedge funds, as well the low-volatility strategies that work in specific niches or implement market-neutral trades, the AAC now has an overweight view on directional strategies. Long-short equity and credit managers have been benefitting from rising dispersion in the performance of individual names, and they now enjoy a decent return on the cash they hold while they are short stocks. Trend-following strategies have started to pick up on genuine momentum in specific markets. While directional, these strategies need not be highly correlated with overall market risk.
For some time now, the AAC has sought out reasonably priced ways to mitigate against rising inflation, and has generally favored inflation-indexed bonds and commodities. Its overweight view on Treasury Inflation Protected Securities (TIPS) remains in place, given its expectation for another 40 basis points or more on the rate of inflation before the cycle peak. While we still recognize their role as a hedge against inflation in the later part of the cycle, our view on commodities has been downgraded based on our expectations for oil supply, and on vulnerability to the forces of uncertainty we have already described: the stronger dollar, weaker growth outside the U.S. and tough talk on trade. By contrast, the AAC has upgraded listed real estate, with its inflation-indexed rental income, as confidence grows that the asset class has suffered the worst of the sell-off it typically endures at the start of a rising-rates cycle.
Finally, perhaps the AAC’s most nuanced view is to be found across the fixed income asset classes. The investment grade view remains underweight and the view on high yield is upgraded to neutral, while emerging markets debt is maintained as an overweight with a preference for hard-currency over local-currency bonds. What links these views is the attractive opportunity we see in short-duration bonds in all three markets.
After a rise in short rates that has flattened yield and credit curves, the AAC sees relative value at the front end even in investment grade—a longstanding underweight. For U.S. investors, an additional lift of approximately three percentage points per annum is available from European credit simply by hedging the exposure back to dollars, given the unusually wide rate differentials between the two currencies.
This relative value at the short end of the curve is clearer still in high yield and emerging markets. At the end of June, the Bank of America Merrill Lynch U.S. 1-5 Year High Yield Constrained Index was yielding just seven basis points less than the full index. This is attractive value for investors seeking good-quality, lower-volatility credits with minimal interest-rate sensitivity and limited supply, particularly relative to the somewhat overheated loan market where covenants are deteriorating. In emerging markets, the one- to three-year bonds in the hard-currency JPMorgan EMBI Global Diversified Index were actually yielding 31 basis points more than the full index.
“We are cautious on rates, but at short durations you can build an investment grade portfolio, add a dash of high-quality high yield and emerging markets debt and come out with around a 4.5% yield,” commented Ashok Bhatia. “We think that’s a good place to be at the moment.”
Experience tells us that summer, with its abandoned trading desks and sometimes gappy pricing, is often not a good time to get caught on the wrong side of the market. That goes double when there is as much uncertainty around as there is today. The AAC’s upgraded view for U.S. assets reflects a recognition that nervous investors tend to head there for safety, but it also brings our overall view on regional market exposures toward neutral. We believe that the rest of the world will reconnect with U.S. growth as the year matures, but it remains too early to express that conviction with clear views on market risks. Instead, the AAC is seeking nuanced, idiosyncratic ways to stay connected with that conviction while mitigating potential downside risk. We are finding the current environment rich in those opportunities.