Quarterly Investment Outlook - July 2019

Summary

• Goaded by central bank easing moves, equity markets have broken through to new highs. But the simultaneous rally in bonds, with falling long duration yields, continues to suggest a mismatch in views. Equities think economic conditions will improve while bonds do not.

• Monetary easing is a response to creeping weakness in the global economy amid big difficulties in global manufacturing and trade. Trade volumes could now shrink outright.

• The US Federal Reserve’s dramatic change of monetary stance at the start of the year continues to create waves in markets. Interest rate markets have taken the central bank’s view on the risks to the economic outlook and then gone further towards a pessimistic stance.

• The declining term premium, now deeply negative, is a key explanation for such low US long duration yields. A big reversal looks unlikely and sets a hard limit to hopes for yield reversion.

• Credit markets have rallied with equities, but differentiation within the market shows that there is more than meets the eye. A more defensive higher quality approach to credit risk will help.

• Equity market upside is constrained by weak fundamentals shown in both earnings and valuations. With upside potential now running low, a debate over how much equity risk to reduce and how quickly is timely. De-risking now has low opportunity cost in foregone gains.

• Global macro hedge funds have had a very long wait for market volatility to pick up. It is now happening, but slowly. Returns versus equities should stop disappointing quite as much.

• Which asset classes will diversify and protect in the next downturn? There are lots of ‘if’s’ and ‘buts’ but a view is best taken now to ensure that adequate protective buffers are in place. It will be worth the effort to ask and act now rather than reacting to poor market conditions later.

Global Outlook

Bonds and equities seeing outlook very differently

The rebound in risky assets continued into the second quarter, helped by central bank assessments that more easing was needed and on its way. While such expectations naturally helped shorter duration bonds, strength in longer durations where global yields fell markedly, was less easily explained. In fact, the latter suggested growing pessimism over the economic outlook. This chimed in with what central banks have been saying but has diverged from the upbeat mood in equity markets.

It is possible that equity markets are expecting easier monetary policy to spur an economic rebound while also believing that trade conflicts will subside. Bond markets, on the other hand, are seeing current globally soft economic conditions as less amenable to improvement. Whatever the explanation, there is little doubting the impressiveness of the stock market rebound in 2019. This has been one of the strongest first half-year market performances for a very long-time. Taking the longer view, a new record has now been set for the length of a bull market (now about 10 years long), eclipsing the 1990’s run, though market gains then were somewhat larger.

Trade-led economic slowdown

Evidence accumulates on the dampening effects of trade conflict and uncertainty on economic activity. Global manufacturing activity is now in the doldrums. The causal factor behind this appears to be disruption in global trade flows and supply chains from rising import and foreign investment barriers, but also from an expectation of more escalation to come. As the chart below shows, global trade flows have stalled badly and could be poised to shrink outright, typically only seen in global recessions.

The question is whether this slowdown in global manufacturing will lead to a broader economic deceleration that risks turning into outright global recession. Manufacturing is less important than it used to be in US, but this activity still employs a lot of people, even more so proportionately in the likes of China and Germany. Employment and income losses here could spill over elsewhere. A further trade conflict escalation would increase the risks to economic activity and it is this worry that is hanging heavily over global interest rate markets. While some Federal Reserve easing helps at the margin, it cannot fully forestall a growing negative impact from trade conflict and the capacity to use monetary stimulus outside of the US is very limited. We see a clear and present danger that the economic environment looks worse rather than better over time.

Interest Rates

Global interest rate expectations fall further

The effects of the US Federal Reserve’s sudden pivot on its interest rate policies in January of this year continue to reverberate. Last November, US interest rate markets were expecting the US Federal funds rate to climb from the then 2.25% to about 3.25% by the end of 2019. The January change in the Federal Reserve’s language transformed this outlook. Today, markets expect this year to finish with the policy rate at a lowly 1.75%. This is quite a turnaround. At current Federal Funds rate, this amounts to about 75 basis points of interest rate easing in half a year.

Why are interest rate markets taking such a view? It is arguably going beyond echoing the US Federal Reserve’s view that downside risks to the US economic outlook dominate, reflecting fallout from the trade conflict and a return to slower growth after the expiry of the tax cut stimulus through 2018. Relatedly, the Federal Reserve also expects inflation to undershoot targets at unchanged interest rates. Rate cuts are insurance to prevent growth weakness taking hold and prevent inflation slipping lower.

As would be expected, this change has impacted non-US markets too. European interest rates were already very low well before growing pessimism on the outlook and the spill-over effect of expected US interest rate cuts took hold in recent months. Here the global trend towards monetary easing has therefore taken the form of an expected step-up of quantitative easing by the European Central Bank.

US treasury yields – the ‘term premium’ goes even more negative

It was not supposed to have happened this way. For some years, the so called ‘term premium’ the reward for bondholders taking duration risk at the longer end of the US yield curve has been negative, i.e. a penalty instead of a reward. This was mostly attributed to the effects of quantitative easing which were argued to depress term premiums given that the Federal Reserve is not a price-sensitive buyer. Subsequently, it was thought that central banks stepping away from supporting their bond markets directly might change this, reverting term premiums towards positive levels. However, this has just not happened. The two most widely used measures of term premiums have moved still lower and are currently at all-time lows of around -80-90 bps for 10-year durations². It may reflect an expectation that rougher economic times will bring central banks back into raising bond purchases again, or it could be very strong duration demand from risk averse investors. The answer to ‘why’ is unknown. What matters is the reality that depressed term premiums are a key factor in depressing long duration yields beyond just the effect of lowered Federal Reserve interest rate expectations.

Will these bond market conditions change? It is possible that large or still larger US budget deficits and returning inflation fears (more so if the Federal Reserve begins directly financing the US government through quantitative easing), could bring a risk premium back into bonds. As things stand, however, we take the view that though the term premium may become less negative, it is unlikely that a reversion to positive levels is coming in the foreseeable future. In turn, this means that though long duration yields may tick-up if the Federal Reserve cuts rates less than now expected, no big yield reversion is on the cards. Those hedging rate risk need to bear this very limited expectation for yield reversion in mind. Further, there remain recession scenarios in which yields could easily fall further.

Credit Views

Credit ‘canary in the coal mine’?

The recent rally in risky assets prompted by the promise of monetary easing from central banks has helped credit too. Credit spreads over government bonds have tightened, though at the time of writing, they are short of reaching their lows from last year, a less sparkling run than for equities which have pushed through to new highs recently.

More revealingly, underneath the headline move in credit spreads, performance dispersion within the market is rising. There is now a tendency for lower quality credits to underperform, significant given that good market conditions normally see the reverse. It suggests that the credit market, at any rate, is less optimistic than might appear from the trend in average spreads. As the chart below shows, within global sub-investment grade, we see lower quality underperforming relative to grade rungs higher up, a level of performance dispersion that is greater than during the sell-off late last year. Since credit has typically led the cycle in risky assets, ahead of equities, such dispersion trends bear watching. If it increases, broad market risks will rise too.

A defensive/quality focus in credit

Our preferred credit approach is focused on a quality-orientated conservative approach that is cautious and selective in taking credit risk. This is a way to manage credit disruption risk, now significant given the erosion in credit quality we have often discussed in the past year. It applies with equal force in any new investment in private credit. A much more sustained version of the trends we saw in the closing weeks of last year before central banks came to the rescue is a big danger for credit markets as we look ahead.

Relatedly, we have, after strong performance in the year to date, become more cautious on local currency emerging market debt. This remains a strategically attractive asset class and emerging currencies still offer upside potential over longer-term horizons. However, current trade conflicts and the likelihood of more risk aversion arriving will not be helpful for its medium-term performance.

Equities

Upside now more limited

After such large market gains year-to-date, upside potential has dwindled sharply. Though current conditions are still within what we have described as a ‘transition market’ environment rather than worse, we do see that we are further along this phase to a point where the room for gains continues to shrink. Equally, the chances of market drawdowns are higher to a point where the onset of bear market conditions, by which we mean a sustained market fall of greater than 20%, may not be that far away.

Why do we believe this to be the case? Essentially because macroeconomic and market conditions are pointing that way. As we noted, the market rebound is based on the view that monetary easing could lift current weak conditions, extending the life of the current US expansion, already the longest in the past 150 years. The problem is that easier money is a response to the global economic drags from trade conflict and soft economic activity in Europe and China. It could cushion a further activity slowdown, but given what can be done, it is unlikely to spur much of an economic rebound. Bonds clearly do not believe the rebound story, already seen in the twelve months ahead (July 2020) US recession probability of 1 in 3 recently signalled by the New York Federal Reserve’s widely used measure of risk to the economic cycle.

When we look at equities directly, neither valuations nor earnings appear to offer much fuel for the market. The current forward P-E ratio of 17x for the US market is high. Neither does the likely fall in corporate profits (earnings per share) in 2019 given continued sharp downgrades to earnings expectations, throw off much optimism. As we noted at the start of the year, share buybacks by US companies have been a key market driver of the 2019 rebound, given the absence of other buyers. This could continue near-term, but increasingly appears as a tactical or shorter-term market support only.

De-risking has low opportunity costs now

What should be done? Precisely timing a sustained large market breakdown is almost impossible, but this should not matter very much if room for sustained gains in the market is small. In other words, the opportunity cost of foregone market gains in de-risking is currently small. Given some funded status improvements, many US plans will have been moving slowly towards lower reliance on equity risk already in the past few years. Continuing or moving faster down such a de-risking path seems reasonable now. Where equity reliance remains substantial, portfolio risk can be mitigated by a switch at the margin to other asset classes which still offer return at lower risk. Alternatively, direct protection solutions can be found through using option strategies or utilising funds which gain from market falls. Both bring some new governance requirements, but Aon advice and support is readily available.

Hedge Funds

Global macro - waiting for volatility to pick up?

One area with a claim to diversifying equity risk is in global macro hedge fund strategies which will typically aim at a very low correlation with equities. After good performance spanning the 2007-9 crisis period, they have, with some exceptions, generally struggled to deliver much by way of positive returns after fees. The finger of blame for disappointing performance is usually pointed at central banks for suppressing volatility in markets which hurts such strategies. It is true that volatility has been falling or simply low for much of the past decade, though it has picked up across both fixed income and equities over the past year (see chart above).

A positive relationship between performance in macro strategies and market volatility means that any prolonged period of higher volatility should help. Also, as equity market returns dwindle, relative returns will compare better. This makes global macro offer something ultimately quite valuable. Simple past comparisons with equity market performance could mislead given that a full market cycle is incomplete. Even so, these strategies should be seen delivering a modest positive and smoother return profile than anything much more ambitious. The hedge fund universe has changed markedly, with growing competition, which make the performance strength of the last financial crisis appear less likely.

Diversifiers

Not so easy to find the winning formula

This is a logical moment to ask where the genuine and robust diversifiers of equity and credit risk are to be found given a widespread expectation that risky assets will come under more sustained pressure. It is harder than it looks to answer this. The standard indicators of co-movement – so called ‘correlations’ (the lower, the better) may not work so well because correlations can reverse or become unstable in unusual market conditions. Correlations also do not indicate performance directly, so low correlation approaches may help portfolio risk, but performance could fall well short of delivering even modest return expectations. This is especially so if certain areas are more susceptible to swings in performance that come from reactive changes in investor demand, particularly from retail investors.

This is an involved and complex area and the bottom line here with diversifiers is that they need to be assessed with up-to-date and forward-looking expectations rather than just looking back at historical data. After all, we live in highly abnormal times, amply indicated by the way interest rates are at rock bottom levels a decade after the end of the financial crisis. Past performance and market behaviour has seldom seemed less relevant than they do at present.

Our view is that it is a very good time for clients to ask questions on the robustness of their current portfolios to a market downturn. This is essential to form a view on whether they have adequate diversification embedded into portfolios at present.

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^{Appendix: Index Definitions}

^{S&P 500 Index – The market-cap-weighted index includes 500 leading companies and captures approximately 80% of available market capitalization.}

^{Russell 2000 Index - The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.}

^{MSCI EAFE Index $ - The MSCI EAFE Index is designed to measure the performance of the large and mid-cap segments of developed European Australasian and Far East Markets. The index covers approximately 85% of the free float-adjusted market capitalization and is measured in USD dollar terms.}

^{MSCI EAFE Index (Hedged) - The MSCI EAFE hedged Index is designed to measure the performance of the large and mid-cap segments of developed European Australasian and Far East Markets. The index covers approximately 85% of the free float-adjusted market capitalization and is measured in hedged dollar terms.}

^{MSCI Emerging Markets Index – The MSCI Emerging Markets Index captures large and mid-cap representation across Emerging Markets (EM) countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country and is measured in USD terms.}

^{Bloomberg Barclays Capital Aggregate Index - The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.}

^{HFRI: The Hedge Fund Research, Inc. Monthly Indices (HFRI) are fund-weighted (equal-weighted) indices. Unlike asset-weighting, the equal-weighting of indices presents a more general picture of performance of the hedge fund industry. Any bias towards the larger funds potentially created by alternative weightings is greatly reduced, especially for strategies that encompass a small number of funds. All single-manager HFRI Index constituents are included in the HFRI Fund Weighted Composite, which accounts for over 2000 funds listed on the internal HFR Database.}

^{CBOE VIX Index: Tracks the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.}

^{ML MOVE Index - The Merrill lynch Option Volatility Estimate (MOVE) Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2, 5, 10, and 30 year contracts}

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