Monthly Investment Letter: Finding value and managing risk

Monthly Investment Letter

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Markets remain volatile following one of their worst single months since the bull market began in 2009.

The sell-off was driven by investors beginning to question the sustainability of three of the key assumptions that have supported equities in recent years: supportive monetary policy, strong earnings growth, and solid economic data.

Global equities remain 7% shy of their peak in local currency terms, and we believe this creates a value opportunity. After removing some equity risk in July because we thought that macro headwinds were underestimated, we recently added to our global equity overweight following the October sell-off. We also remain overweight emerging market (EM) dollar-denominated sovereign debt.

Of course, value alone is not a catalyst. We are also considering the evolution of upside and downside risks. Some aspects of the risk environment remain challenging. Market momentum is weak and credit spreads have widened, pointing to a market more vulnerable than usual to volatility and drawdowns.

All else being equal, we will be looking to continue to combine our risk-on overweights with a number of countercyclical positions.

But we also shouldn’t overlook the potential for positive surprises, even if they can be hard to envisage in an environment of fragile sentiment. We will be looking ahead to the G20 meeting at the end of November. Expectations are rightly low, but any signs of progress between the US and China could be taken positively. The normalization of auto production and fiscal stimulus in Europe could lead to positive data surprises there. And recent data from China suggests that policy stimulus will gain more traction than markets currently anticipate. With expectations low, material progress on Brexit and the Italian budget negotiations would also be received positively.

All else being equal, until some of the current macro risks resolve themselves, we will be looking to continue to combine our risk-on overweights with a number of countercyclical positions, like our overweight position in 10-year US Treasuries. In our FX strategy, an overweight on the Japanese yen versus the Taiwan dollar would provide a partial portfolio hedge against a global market shock. Within non-US developed equities, we favor Canada over Australia.

Economics and valuation support equities

It has become a difficult year for many major equity markets. Returns from emerging market stocks are down 10% year-to-date, Chinese markets 17%, and European equities 6%. Among major markets, only US equities have delivered positive performance, up 3%, but even this represents a significant derating in valuations when we consider that earnings have risen by 26%.

We think that the recent sell-off provides investors with a good entry point, and we recently increased our overweight allocation to global equities. When deciding to make this change, we had to consider whether the bull trend is intact and how we think about valuations.

Downturn isn’t imminent

A lot could change over the next 12 months regarding future expectations for a peak in the business cycle, but for now the data is not lining up with prior recessions. Consumption almost always decelerates going into a cycle peak, but in the three largest developed market economies, it is accelerating. So too is investment in the Eurozone and Japan. And employment growth is showing little sign of slowing down, with the US adding more than 250,000 jobs last month. Inflation is also only adjusting slowly; since the end of March, US core PCE inflation, the Federal Reserve’s preferred inflation measure, has been within +/–0.1% of its 2% target. Eurozone core CPI has edged higher from a 0.8% low in April to 1.1% in October.

Valuations are relatively attractive

We believe markets are in a bottoming process after the 9.9% drawdown in the S&P 500 from late September to late October. Corrections within bull markets tend to present good buying opportunities, but it is very difficult to time the bottom perfectly. Also, the 20% decline in the S&P 500 trailing P/E from 21x in late January to 17x today suggests investors have become more cautious. We note that since 1980, whenever valuations have compressed this rapidly, stocks tend to perform well over the next six months.

On a forward basis, we believe equity valuations now look relatively attractive compared with government bonds, especially in emerging markets and Europe – even if we use our own below-consensus estimates for 2019 earnings, which include the expected impact of tariffs in the US and Asia and a modest slowdown in headline economic growth.

Looking at these estimates, EM equities, trading at around 11x forward earnings, are at a discount to their 30-year average of 13x. The forward P/E of Eurozone stocks, at roughly 13x, is also below the long-term average of 14x. And although absolute valuations in the US are not as cheap – at just over 16x 12-month-forward estimate of earnings versus a long-term average of 15.6x (see Fig. 1) – they remain attractive relative to bonds. The forward US equity risk premium of 4.8% is above its long-term average of 3.2%.

Elsewhere, we see value in EM dollar-denominated sovereign bonds. Despite the current uncertainty in EM, we think the 385bps yield spread on these bonds (based on the EMBIG Diversified index) over US Treasuries is attractive.

Watching for positive surprises

We are also watching closely for potential positive surprises, which, when combined with a decent macroeconomic backdrop and favorable valuations, could lead to a further rally in risky assets.

In the months ahead, we see potential for positive surprises in a number of areas:

1. China’s stimulus.

The Chinese government has started to take a proactive approach toward slowing growth and is using fiscal and monetary policy to offset the negative effects of US tariffs. There are signs it is starting to have an impact. The sharp fall in fixed asset investment growth this year has shown early signs of stabilizing, and the latest PMI survey data was better than expected. The impact of tariffs has also been partly muted by a weaker yuan. For next year we expect further yuan depreciation and forecast USDCNY at 7.00, 7.10, and 7.30 over three, six, and 12 months respectively compared with 6.95 currently.

2. US-China trade tensions.

The G20 meeting in Buenos Aires at the end of the month could prove an upside catalyst as markets seem to expect little progress on trade issues. Our base case is for a continuation of trade hostilities into next year, with the US raising its tariff rate on USD 200bn of Chinese products to 25% on 1 January. But we still assign a 20% probability to a more market-friendly outcome, such as an at-least-temporary agreement at the G20 meeting. Actual progress in negotiations would benefit Chinese and US assets.

3. European growth.

While recent European economic data has weakened, there are signs that this was due to one-off effects such as the introduction of new emission test procedures, which led to a sharp decline in German car production. German industrial production picked up in September, with output rising 0.8% from a year earlier (see Fig. 2). If one-off causes were indeed the reason for the soft patch, there is a good chance that economic momentum will pick up again and surprise on the upside in the first half of 2019.

Managing risks

While we think there is opportunity to capture value in risky assets, current economic data is generally supportive, and there are potential catalysts to help equities rally in the months to come, we also have to acknowledge that the economic environment will become more difficult as we head into 2019 with the potential for negative surprises.

Challenges for 2019

We expect the economic backdrop to become more challenging next year because aggregate central bank balance sheets are continuing to shrink, US-China tariffs are beginning to weigh on trade, and the positive effects of US tax cuts are starting to wane.

Other cyclical indicators are also cause to exercise some caution. High yield credit spreads, which can be a leading indicator for equity markets, have widened by 50bps in the US and in Europe from their October lows (see Fig. 3). Corporate leverage is rising and has attracted the attention of policymakers, particularly in the US leveraged loan market. We are monitoring a number of metrics for early warning signs including bank lending conditions tightening, credit rating downgrades far outnumbering upgrades, and real year-on-year debt growth in US non-financial corporate debt approaching the previous cycle peak of 10%.

Downside risks to watch

• Faster rate hikes. The market is pricing in less than a 10% probability that the US federal funds rate will be above 3.25% by the middle of next year. Our base case is for four interest rate hikes by the end of 2019 with no further hikes beyond that. If the US labor market reaches an inflection point, causing wage growth to accelerate much more rapidly and inflation expectations to rise, we think it’s possible that the Fed could become more hawkish and raise rates faster than markets currently expect.
• US-China trade tensions could escalate further. We do not currently foresee that the US will impose another round of tariffs on Chinese products – President Donald Trump’s so-called “Phase 3.” But we see a 30% chance that, if US-China talks over the coming weeks should fail, the US may impose tariffs on nearly all Chinese imports early next year. These tariffs on the remaining Chinese goods will be disproportionately more disruptive than those that have been imposed so far, in our view.

For more on our upside and downside risk scenarios, please refer to our Global Risk Radar publication.

Nuanced but navigable

With the right strategies in place, we believe this nuanced and challenging investment environment is navigable.

In our tactical asset allocation we overweight global equities and emerging market dollar-denominated sovereign debt to benefit from good economic data, favorable valuations, and the potential for positive surprises.

But we also recommend a number of countercyclical positions, which can help protect portfolios in the case of a sharper economic slowdown than we expect, or in the case of our downside risk scenarios materializing.

At present, we see the key tactical opportunities as follows:

We increased our overweight position in global equities.

• As discussed above, we saw the October sell-off as a bull market correction, rather than the start of a bear market. As such, it presented a buying opportunity. Even using our own below-consensus earnings estimates, which factor in the first rounds of US-China trade tariffs on earnings, equity valuations look appealing. While risks remain – especially from rising US real interest rates and US-China trade tensions – we think the value offered by global stocks justifies tolerating the potential for higher volatility.

We expect Canadian equities to outperform Australian equities over the coming six months.

• The Canadian market is attractively valued and benefits from stronger earnings momentum (see Fig. 4). Canadian equities should benefit from an expected rebound in oil, which we forecast will rise from USD 66/bbl at present to around USD 85/bbl over the next six months.

We overweight 10-year US Treasuries.

• We believe that the close to 3.2% yield on the 10-year US Treasury has now largely priced in the full tightening cycle from the Federal Reserve, and we do not expect a significant increase in yields from here. Nothing in the Fed’s statement in November pointed to an acceleration in the pace of monetary tightening, and the core PCE inflation gauge has been steady at 2% for the past two quarters. In addition to offering an attractive yield, 10-year Treasuries serve as an important portfolio stabilizer in a period of rising equity market volatility, in our view (see Fig. 5).
• The average duration on 10-year US Treasuries, where we are overweight, is 8.5 years, while for US government, where we are underweight, it is 6 years. Overall, this reflects our preference for longer duration, because the long end of the US curve has already priced in most of a full rate hiking cycle.

We are overweight EM USD-denominated sovereign bonds.

• Despite the current uncertainty in EM, we think the 385bps spread on emerging market USD-denominated sovereign bonds (EMBIGD index) over US Treasuries is attractive. This asset class is also well placed to gain from the recent positive trend in Chinese economic data. The Citi Economic Surprise Index, which measures data relative to expectations, has improved by around 20 points over the past month to stand at 4.

In our FX strategy, overweight the Japanese yen relative to the Taiwan dollar.

• We expect this position to perform well in the event that China’s growth starts to slow, or if the market begins to fear a slowdown in global trade. Taiwan’s economy is very trade-dependent, while the yen typically appreciates during periods of risk aversion when Japanese investors repatriate capital, boosting the yen.

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