Central Banks To The Rescue? Don’t Count On It

Key Points
Regardless of near-term developments on the trade front, we expect growth to slow and think investors should consider more defensive positioning, including:
• Favor credit over equities; within credit, consider investment-grade and high-yield bonds.
• Within equities, lean into defensive factors, such as quality and safety, and consider the US, which could outperform in choppy markets.
• Our differentiated views:
– Credit over equities
– US over developed market and emerging market (EM) equities
– Don’t expect major US dollar sell-off
• Upside risks: Aggressive policy stimulus, trade war eases
• Downside risks: Trade war worsens, populism

We think trying to predict the next episode of the trade drama, which has dominated market sentiment so far this year, is futile. Instead, we posit that tensions between the US and China will be a lingering headwind regardless of any near-term developments, and we anchor our outlook to our view of the global economy, monetary policy, and valuations. Specifically, we expect shrinking business investment to contribute to already slowing global growth, and we think the central bank response will ultimately underwhelm markets. Taking all of this into account, we continue to recommend that investors consider positioning their portfolios more defensively than in recent years.

Consistent with late-cycle dynamics, we still favor a quality bias — credit and US Treasuries over equities, and within credit, investment-grade and high-yield bonds over bank loans. We think that spreads look attractive versus equity valuations and that duration could add to returns. Longer-maturity US interest rates could decline, but we have a more cautious view on rates in Europe and Japan, which are now negative up to 10 years. Within equities, we prefer the US — while it’s at the center of the trade conflict, its economy is still relatively strong, and the market has tended to outperform when the broader environment has been choppy (Figure 1). We prefer leaning into defensive factors, such as quality and safety, which have typically been found in a diverse range of traditional sectors.

 

Figure 1: US equities have tended to outperform in choppy markets
Percent of quarters the US equity market outperformed and underperformed other markets when those markets experienced negative quarterly returns

Time period: 1999 – 2018. Number of observations: Japan 37 negative quarters, Europe 34 negative quarters, emerging markets 31 negative quarters. For example, during that time period, the Japanese market experienced 37 quarters of negative performance out of which the US market outperformed 31 quarters (84%) and underperformed six quarters (16%). Past results are not necessarily indicative of future results. | Sources: Bloomberg, Wellington Management

 

Global fundamentals and the limits on central bank action
We believe the global economy will continue to slow in the coming quarters. Thus, we are not expecting a lift in inflation or interest rates. In fact, central banks in developed and emerging markets have changed their tune and are now generally cutting rates. In addition, quantitative easing (QE) is making a comeback. The European Central Bank (ECB) is likely to restart its program, and the Bank of Japan (BOJ) could be compelled to respond.

However, unlike in recent downturns, we see monetary policy mitigating the downside but not eliminating it. Market skepticism, asset-purchase limitations, and the potential adverse effects of greater negative yields on banks are all issues we see challenging risk assets. We also think the ECB and the BOJ have few effective and easy levers left to pull compared with the Federal Reserve (Fed). Meanwhile, expectations for Fed easing seem too high. Market consensus is for approximately four 25-basis-point cuts over the next 12 months, in sharp contrast to the Fed’s projections (Figure 2). At the same time, the market is pricing in slightly higher 10-year yields one year out.

 

Figure 2: The Fed may struggle to deliver what the market expects
Market and Federal Reserve expectations for fed funds rate at end of each year (%)

Sources: Bloomberg, FOMC

 

Credit is more appealing than equities
We find credit relatively attractive because we think rates may fall, valuations look more attractive than US equities, and credit could outperform equities during a slowdown. We remain moderately bullish on US investment-grade credit because it provides duration and the potential for spreads to compress from above-median levels. We are monitoring leverage in this space, which admittedly has risen, but we are comforted that companies are still generating ample free cash flow and should be able to service their debts.

We are also moderately bullish on US high yield because it tends to be more closely tied to the US economy, which seems better positioned than other developed economies, and spreads are near median, giving them at least some room to narrow. High yield has developed into a more diversified sector with improved average credit quality and is now a permanent source of funding for many companies.

We remain neutral on bank loans as short-term rates may fall and reduce demand for floating-rate instruments. We have not lowered our view on bank loans because they provide steady income and have historically been a low-beta investment. We also remain neutral on emerging market debt. The sector offers long duration and may provide compelling opportunities at the country level, but we are concerned that the index is dominated by large countries with structural overhangs, such as Argentina and Turkey.

Country and regional equity fundamentals
US
We think the US economy will continue to be a relatively solid performer but that its pace of growth will deteriorate as waning fiscal stimulus is overwhelmed by the negative impact of tariffs. Capital expenditures should slow as uncertainty about the US administration’s use of tariffs weighs on business investment. However, US consumers seem resilient and may help the US avoid a sharper correction. In addition, we do expect the Fed to cut rates and provide some support.

With global growth deteriorating and trade risks looming, we would prefer to take equity risk in the lowest-beta markets and thus are moderately bullish on US equities. Although they have historically been higher beta, small caps look cheap and may be more insulated from the trade conflict. We also expect quality and safety factors to do well in a slowdown.

Europe
European economic growth continues to slow, and overall we think leading indicators are pointing to further weakness ahead. Brexit risks will linger throughout the summer and fall and could impact business and market sentiment. Further, we would generally shy away from Europe this late in the cycle, given that it is highly exposed to global trade and turns in the global economic cycle. However, we are maintaining a neutral stance given that some leading indicators may be bottoming (partially aided by a weaker currency), the consumer is still well supported, and valuations are cheap (Figure 3).

 

Figure 3: Could falling European data be bottoming?
ZEW Eurozone (EZ) growth expectations and Markit Manufacturing PMI

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE. | Source: Bloomberg | Chart data: October 2004 – June 2019. X-axis scale December 2004 – September 2019 due to ZEW EZ growth expectations being forwarded three months. ZEW EZ growth expectations data is from November 2004 – June 2019 (i.e., first data point represents November 2004 and final data point represents June 2019). Markit EZ Manufacturing PMI data is from December 2004 – May 2019.

 

Japan
Japanese economic growth, which had held up surprisingly well, is showing signs of fatigue. Consumers are still well positioned thanks to a historically tight labor market, but the business side of the economy has seen deterioration in both hard data and leading indicators. We are concerned that the economy and the stock market are dependent on weakening in the yen, which we find unlikely given the currency’s role as a safe haven in times of stress. What’s more, if the authorities go through with the value-added tax hike scheduled for this fall, the cycle could be further damaged. We think Japan is ripe for stock picking as few companies are covered by the sell-side and corporate governance is improving in some cases, but we find the market’s beta potential less appealing and have a moderately bearish view.

Emerging markets
Given that emerging markets may struggle to cope with slowing global growth and are the highest beta of the major equity markets, we have lowered our view from moderately bullish to moderately bearish. China’s domestic cycle appears to be slowing, and while we expect some stimulus in response, the government will likely take a measured approach. However, we do think select countries may be attractive for investors with the necessary risk tolerance at this stage of the economic cycle. In particular, we favor countries with slowing inflation, looser monetary policy, and the long-term potential to benefit from the disruption of supply chains in China, such as India, Indonesia, Malaysia, and Vietnam.

Commodities
Because inflation is unlikely to rise in a slowing growth environment, we don’t see a case for adding to commodities. In addition, we think commodity performance is likely to be driven more by demand, which will be muted amid slower growth, even if supply is constrained by geopolitical events. We do, however, see a structural role for commodities as they are the only asset class that has historically had a high beta to changes in inflation. In today’s environment, precious metals may serve as a hedge if the global economy is headed for a hard landing or a larger-scale trade war.

Risks are elevated
Economic and market risks are elevated as a result of the US administration’s cavalier use of tariffs at a time when global growth is slowing. Following tariff threats aimed at forcing Mexico to address immigration issues, it may be hard for businesses to trust that the US won’t threaten or use economically damaging measures in other geopolitical disputes that are outside the economic realm. While not our base case, there is a chance this uncertainty cripples business investment and ultimately infects the job market and consumers. Further, while US consumers remain in solid shape, if the final tranche of tariffs on China’s remaining US$300 billion of US exports goes into effect, it will hurt consumers and our confidence in their ability to weather the economic downturn. Supply-chain disruptions as a result of tariffs or other restrictions could also cripple some companies’ profits and create undue corporate stress. Certain upside risks could affect our views — if monetary policy is more aggressive than the market expects, for example, or if a breakthrough on trade substantially relieves tensions.

Investment implications
Credit over equities — We think credit valuations look relatively attractive versus equities, US rates may fall, and credit could outperform equities in a slower growth environment while providing some income.

Defensive factors and sectors — Consumer staples, health care, telecommunications, and utilities may offer opportunities for stable earnings and cash flow — defining characteristics of the safety and quality factors we favor.

High-quality government bonds — Inflation is unlikely to rise, growth is slowing, and central banks are moving toward easier policy. We think longer-maturity US interest rates in particular look attractive.

Precious metals for downside protection — Precious metals may be a good disaster hedge if trade tensions escalate and the global slowdown intensifies.


by Wellington Management
Daniel Cook, CFA, Investment Strategy Analyst
Daniel Cook analyzes and interprets markets and translates this work into investment insights for clients. He also consults with clients on strategic asset allocation issues.

 

Nanette Abuhoff Jacobson, Global Investment and Multi-Asset Strategist
Nanette Abuhoff Jacobson consults with clients on strategic asset allocation issues and works with investment teams throughout the firm to develop relevant investment solutions across asset classes.

 

Third Quarter 2019


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