Bond investors face a very difficult investment environment: Yields are near record lows, central bank actions have caused widespread volatility, and concerns persist over the prospects for the global economy. Yields are likely to remain low, protecting existing portfolios against sudden declines in value, but weak US corporate balance sheets could signal volatility. It is still possible to make money in this environment, but rising correlations between equities and certain bond assets are complicating matters. Fixed income investors therefore have a simple choice. Do you want your bond portfolio to generate returns or provide safety? Investors need to decide whether they want to access the higher yields available from emerging market, high yield, and corporate debt – which means accepting higher correlations with equities; or the greater diversification available from developed market sovereigns – which will mean accepting lower yields.
Politicians in Europe, America and Japan are openly talking of using fiscal policy to save the economy. Stock markets have noticed. Top-down investors have been placing their bets on a shift to fiscal policy. Some stocks have started to behave as though investors believe a macro policy change is coming. Such moves look speculative. It is far from clear what kind of policy change will occur, and which types of stocks would logically stand to benefit. The last time fiscal policy stimulation was used in earnest was back in the 1960s and the economy was very different.
I have learnt from experience, knowing when not to have an opinion can be just as important as trying to form one. Forming an opinion is deceptively easy, but forming an opinion on such a particularly slippery topic is dangerous: it is easy to be wrong and it is easy for a potentially flawed opinion to infect other decisions, like whether a particular stock looks good or bad. On the topic of fiscal vs. monetary policy shifts, having no view is probably the right view for the moment.
The US election and the prospects of a Trump presidency loom large over markets. The Brexit vote highlighted how current conditions are polarising electorates, with more extreme parties and candidates garnering support. Polls are currently leaning against Trump, but we have seen polls being wrong before! A Trump win would undoubtedly cause a sharp sell-off in markets, but the actual economic impact will evolve more slowly. The defining feature of US politics over the last decade has been the divided nature of Congress, which has hamstrung the flexibility of US policy. Whoever wins, this dynamic is likely to make the translation of campaign promises to policy tortuous.
It is becoming clear that European investment banking, and FICC – fixed income, currencies and commodities – trading in particular, is in structural decline. Deleveraging, slowing money velocity and a shift towards derivatives clearing are weighing on revenues. US investment banks have stolen a march on the European banks by taking 7 percentage points of revenue market share in six years. The depth and concentration of US capital markets relative to Europe puts US investment banks in a much more dominant position and they will continue to take market share.
US equities still look attractive relative to the return outlook from government bonds – but it is the first time in this unusually long cycle our Asset Allocation Committee’s view on this asset class has fallen below neutral. What concerns us is the valuation of the market. When we look at non-US developed world equities, we see tailwinds from accommodative monetary policy, improving earnings and compelling relative value between earnings and dividend yields and exceptionally low core government bond yields. In the US, the case is less clear. The issue is not that current multiples are too high in themselves – a 17 times forward price-to-earnings ratio is in line with historical averages – but that the earnings growth required to satisfy them seems optimistic in the current environment.
The months since the referendum vote have seen the emergence of an unprecedented disparity between perceived winners and losers. In particular, we believe the recent derating of domestic cyclicals is unwarranted and provides a compelling valuation opportunity – in stocks such as Bellway and ITV . However, not all domestic stock valuations are compelling. The retail sector in particular faces a potentially challenging cocktail of higher input costs, rising living wages and business rate hikes. In a world of low inflation, businesses will struggle to pass on all the cost increases. Therefore, company performance will highly depend on flexible cost bases and being well-hedged. Keys to generating growth will be strong growing sales lines to absorb the higher costs, as well as international operations.
Widespread belief China’s GDP growth is driven by an unsustainable expansion of credit, primarily to the real estate sector, is well founded. Many analysts believe real Chinese growth is about 5%, so authorities aiming to hit the official target are compelled to increase the supply of credit to the real estate market, even if this funds loans that are bound to go bad. Why is the economy growing slowly? Looking beyond official statistics to the metrics released by China’s trading partners, we find evidence of the secular slowdown being experienced by the rest of the world.
This is driven by a decline in demand, upon which China’s old export-oriented model of growth was dependent. Growth in Chinese exports is negative, and has been all year. We see two Chinas: the old, and the new. The old is burdened by an outdated growth model, sustained by debt and subject to reforms – such as the country’s new state-owned enterprise restructuring fund. China’s nascent economy – featuring growing healthcare, e-commerce, and advanced manufacturing businesses – is what we perceive as its long-term source of growth, and is where we are invested.