Global Asset Tracker: Keeping a clear head late in the economic cycle
Despite evidence of global economic slowdown and expected higher market volatility, which may be exacerbated by geopolitical tensions, tighter monetary policy and a maturing labour cycle, a cautious optimism pervades the market outlook of private banks’ investment offices for the year ahead.
The rapid, chaotic fall in markets in December 2018, one of the worst months in a decade, which left pretty much every major asset class in the red for the year, may have spooked investors. But the probability of a US recession – which has historically driven big market corrections – is still considered low by our panel of chief investment officers, heads of asset allocation and chief investment strategists at 43 private banks which took part in PWM’s fourth annual Global Asset Tracker survey (GAT), conducted in January. Most participants have been among the winners of PWM’s global private banking awards in recent years, together managing $10tn in client assets globally.
While early 2019 has seen the return of some welcome calm and markets have rebounded, can investors still hope for a further rise in risk assets, in the final stages of this long bull run?
“Despite the slowdown, we think probability of recession in the next six to 12 months is still reasonably low, so we still see more upside in global equities,” says Themis Themistocleous, head, European Investment Office at UBS Global Wealth Management. Equities tend to perform strongly in the latter stages of a bull market, with US stocks returning 12 per cent on average in the six to 18 months before a recession, according to the bank’s analysis.
The world’s largest wealth manager, running more than $2.4tn in client assets, maintains an overweight stance on global equities, citing still bright earnings growth and attractive valuations. But believing in the likelihood of further market pullbacks, UBS favours quality stocks, with low leverage, high profitability and lower earnings volatility, focused on neglected sectors such as financials in the US and China, or energy in Europe. It recommends client portfolios should include stabilisers and downside protection, such as a long position on the Japanese yen, offering some cushion in times of volatility.
But the proportion of institutions with overweight tactical allocation to equities is significantly lower than last year – 48 per cent versus 70 per cent in 2018 – with a greater contingent having higher exposure to cash (see Fig 4).
Quantitative tightening and policy mistakes are less of a concern, since the Fed’s U-turn in monetary policy at the beginning of 2019, when chair Jerome Powell indicated low inflation would allow the central bank to be patient in deciding further rate hikes.
“The Fed’s less hawkish tone has been a big contributor to the relief rally of the first few weeks of this year,” explains Niladri Mukherjee, head of Chief Investment Office Portfolio Strategy, Merrill Lynch Private Banking & Investment Group.
Yet, several risks remain on the table, with US-China trade tensions believed the biggest threat for stockmarkets (see Fig 5). Although domestic consumer spending in China is growing at an unprecedented pace, and reliance on exports diminishing, the US is still the largest export market for the country, and the spat is clearly affecting economic growth. Several US companies will also be forced to rethink their supply chains if new trade sanctions are imposed, a fear which contributed to the US market’s decline in late 2018.
However, in-depth interviews with CIOs reveal optimism around the ability of US and China to strike a deal over the coming weeks, based on the assumption both countries will want to create an environment where they can thrive and grow.
The conviction is that President Trump cannot afford damage to the US stockmarket and economy from a fresh round of tariffs. “Whether we get a deal or not depends on the president’s political calculations of how badly he needs it,” says Merrill Lynch’s Mr Mukherjee. However, US presidents tend to make economy- and stockmarket-friendly policies as they head into their re-election year, he adds. And with the 2020 elections looming, Mr Trump is unlikely to buck this trend.
Merrill Lynch is optimistic on the US economy, predicting 5 per cent corporate earnings growth, in line with consensus’ views. This is encouraging, albeit way below the 20 per cent of last year. A more dovish Fed and progress on the US-China dispute also contribute to a positive outlook.
Within its barbell strategy in global equities, the US bank is overweight US equities, in particularly large caps, for their higher quality characteristics, and also overweight in emerging market equities, which provide higher beta or higher risk participation in the global equity market. It has lowered, however, its allocation to international developed market stocks, given high political risks and weak economic data.
Emerging attraction
Emerging market equities top the league table of most attractive asset classes, with more than 80 per cent of respondents expecting the highest risk-adjusted returns this year (see Fig 6). It should be noted that emerging market stocks also featured as high conviction calls in private banking clients’ portfolios in 2018’s survey, but expectations were not met as the asset class was hit by a perfect storm of quantitative tapering, Fed rate hikes, a rising dollar, and concerns about slowing growth.
As a result, today’s valuations look attractive. Sentiment towards emerging market stocks is poor and positioning light, and any good news on the US-China trade deal, combined with the dollar declining and the Fed taking a pause, could be a very “powerful cocktail for emerging market stocks to rally”, believes Mr Mukherjee.
Within global emerging markets, the preference goes to Asian equities. China’s growth story remains a key driver for Asia Pacific economies, and the outlook for China onshore equities is particularly favourable, as domestic firms benefit from double digit earnings growth and increased allocation to MSCI indices, explains Steve Brice, chief investment strategist at Standard Chartered Private Bank.
“Stars seem to be aligned for China A-shares to perform well,” he believes. Despite structural deceleration in growth, Chinese authorities will be able to manage the cyclical slowdown, having plenty of room for fiscal stimulus, and a trade deal between the US and China would be a “massive catalyst” for a rerating of Asian stocks, says Mr Brice.
The main risk around China remains the high level of corporate debt the country has built up to fund its growth. Over the past eight years, it has gone from 150 per cent to 250 per cent, reports Alan Higgins, head of multi asset investment at Coutts. “The authorities are aware, are very smart, and debt has been reducing lately. But the question is ‘can China reduce its corporate debt whilst keeping the economy strongly enough, and people employed?’ ” Coutts is currently seeking a fund investing in A-shares.
In China, the firms likely to be less sensitive to short-term volatility or the country’s slowdown are those benefiting from wealth creation, believes HSBC Private Banking. Rising wealth and ageing demographics lead to rising healthcare spend, and this is particularly relevant to empty nesters, households where the only child has left the house, explains Willem Sels, chief market strategist at the bank. Other beneficiaries of rising wealth in China are firms producing higher quality goods.
“Chinese consumers have changed their consumption pattern. They are no longer looking for the brand, but they seek high quality goods, and are willing to pay for them,” says Mr Sels. Also, he points to select firms, such as construction, engineering and telecom companies, expected to benefit from the government’s fiscal stimulus, aimed at offsetting weakness in global trade.
There is no doubt that, longer-term, China represents a very attractive investment opportunity. “China comes across for being opaque to do business with, data is always questionable and nobody really knows what the central government authorities are doing,” says Mohammad Syed, managing director, Global Markets at Coutts.
Investors should focus on the overarching policies driving Chinese economic activity, seeking to identify investments and companies benefiting from them, both in China and neighbouring countries, he says. He points to the incredible infrastructure projects, such as the “One Belt, One Road” initiative aimed at connecting Asia to Europe, the Middle East and Africa, which covers 65 countries, home to more than 60 per cent and growing of the world’s population. “Chinese authorities are focusing longer term, they are not looking at the five to 10-year cycle, but they are looking at the 1500-year cycle. But they also need their neighbours to rise economically,” says Mr Syed.
The US-China dispute is a “fight for supremacy in the world”, more than a disagreement on tariffs and trade, and will be a long-term issue, believes Stéphane Monier, CIO at Lombard Odier Private Bank. “While trade between the US and China remains stubbornly one-sided, the intellectual property balance in terms of technology firms between the two countries is shifting,” says Mr Monier.
The number of Chinese software companies doubled in the five years following 2009 and China is now home to nine of the world’s 20 largest tech companies, including China Mobile, Tencent, Alibaba and Baidu.
More than two thirds of private banks have an overweight position to emerging market stocks. Yet, their average strategic asset allocation is quite low, at 5 per cent, and it is just slightly higher for emerging market bonds, which are expected to generate the strongest returns in the fixed income space this year (see Fig 6).
But a key issue is that asset allocation strategies follow market capitalisation indices, explains Mr Monier. This means investors are going to end up with approximately 90 per cent of their portfolio in developed markets and just 10 per cent in the emerging world, despite it representing more than 50 per cent of the global economy, on purchasing power parity.
Despite being the “second most aggressive private bank amongst its competitors”, in terms of allocation to emerging assets, Lombard Odier has just 15 per cent exposure in EM stocks and bonds. But with leading benchmarks gradually including emerging market countries, such as China or Saudi Arabia, investors’ allocation to these economies is bound to rise.
“Our intention is to be at the forefront of this trend,” he states. “We prefer our own clients to invest their money early and benefit from other investors buying those assets and pushing the price higher, rather than to be laggard and invest in those countries when the price is already high.”
But as emerging markets are a high beta play it is important to increase exposure gradually. “If you are wrong in the timing, it could really hurt client portfolios,” adds Mr Monier, pointing to volatility and liquidity as key constraints.
Tread carefully
At a such a maturing stage of the cycle, wealthy clients should remain fully diversified and safeguard assets, by being more defensively positioned in portfolios, believes Jeffrey Sacks, head of Emea investment strategy at Citi Private Bank.
This may mean choosing more conservative equities and bonds, he explains, for example large cap companies which tend to offer more transparency in their reporting, have diversified turnover and profits and are typically less leveraged. Citi also recommends increasing currency hedging, while making greater use of capital market products that build in capital protection. Using cash more productively, for example investing in short-term dollar treasuries, is also highlighted.
Thanks to its defensive qualities, healthcare is the sector where the highest proportion of banks, 64 per cent, have an overweight stance. It is also an attractive investment theme, whose long-term drivers are in ageing demographics, growing affluence in the emerging market consumers and technology innovations (see Fig 7).
Across the board, selectivity is key. “This should be the year where active management or long short hedge funds should do reasonably well and can add to returns,” believes HSBC’s Mr Sels. The view that 2019’s market environment will be more favourable to actively managed investment products, compared to 2018, is shared by almost 90 per cent of respondents, and more than 60 per cent expect actively managed products to increase in client portfolios.
“The more you believe in the fourth industrial revolution, which will create winners and losers in each sector, firms that use technology well to their advantage and those that don’t, the more selective you need to be,” he explains.
Some institutions have increased allocation to gold, because of its safe haven characteristics, while others emphasise the importance of adopting a dynamic portfolio management strategy. “When markets go down and you think they have overreacted, you must consider increasing your exposure to stocks, to maintain the equity-bond split in a balanced portfolio,” says Bob Homan, head of Investment Office, ING Private Bank in the Netherlands.
Similarly, investors need to scale equity exposure back and buy bonds, if stockmarkets are rising rapidly. “By using ETFs, we can adapt our portfolios quickly and take advantage of market opportunities,” he explains. Almost 60 per cent of private banks indicate that ETFs represent between 20 to 30 per cent of assets in client portfolios, with traditional market cap-weighted index products and sector ETFs most used (see product parade on ETFs).
Don’t fear volatility
A more standard volatility regime, with intermittent spikes, will return this year, says César Perez, head of investments and CIO at Pictet Wealth Management, but that is not necessarily a bad thing.
“We should not be afraid of volatility, it is just another asset class. You sell it when it is high and you buy it when it is low,” he says. “As we get closer to the end of the cycle, the outcome becomes binary, either recession or no recession. The market is much more sensitive to news flow, that’s why volatility is here to stay.”
Clients are very defensive these days, as they were really taken by surprise by the downturn at the end of last year, and are no longer used to high volatility, reports Manuela D’Onofrio, head of Group Investment and Product Platform at UniCredit. “I think investors will continue to remain extremely cautious going forward,” she says.
In an environment where monetary policies are less accommodative than in the past, Ms D’Onofrio recommends clients take a level of risk which allows them to sleep at night. “Like never before, it is important that we help our clients find their correct risk profile. Otherwise they may end up selling in a market crash, at the worst possible time, instead of looking for bargains.”
UniCredit has significantly reduced exposure to total return kind of strategies, including flexible bond funds and multi-asset solutions. Such strategies have delivered positive returns for several years in a row in the past, capturing a certain percentage of the market upside, but greatly contributed to the lack of liquidity in the market downturn in December, as they were unable to limit losses or contain volatility, with managers finding themselves forced to sell.
More than 40 per cent of banks expect fixed income allocations to rise in their client portfolios in 2019 (see Fig 8). Yet, an overwhelming majority of respondents, 95 per cent, believe equities will continue to outperform bonds.
“Longer term, equities offer more value than bonds. Volatility should not determine your choice of investments,” says Ms D’Onofrio. In the best-case scenario, central banks will keep their balance sheets at current levels, and interest rates are unlikely to move significantly higher going forward, with government bond yields expected to generate very low returns.
“Why take so much risk in high yield or distressed bonds when you can get very healthy dividend yields in equities, with the potential of also having capital appreciation, considering that equity valuations are no longer as overstretched as a year ago?” she questions, making an exception for emerging market bonds, which are expected to offer “very attractive” returns.
There are of course several risks on the horizon, like the significant rise of populist movements which support protectionism, which is bad for the global trade and global economy, she explains. But these political trends are somewhat moderated by financial markets. President Trump has become much more willing to engage and try to find a solution in the trade dispute with China since the US market crashed.
“To a certain extent, financial markets protect us from any sort of political extremism. They are very democratic tools,” adds Ms D’Onofrio.
European woes
Since 2018, the investment outlook has significantly deteriorated for Europe ex-UK equities, and the percentage of respondents (33 per cent) that find them attractive or very attractive has more than halved. Although European stocks look cheaper than global stocks, earnings expectations are not as positive, in general. Only 25 per cent have today an overweight position to European equities today (see Fig 9).
The biggest surprise this year could come from UK equities, which are currently “unloved, underappreciated and hugely under-owned”, says Monique Wong, multi asset investment manager at UK bank Coutts. But there are large, profitable multinational companies in the country, with very attractive valuations, and the currency is cheap.
In case of a “pragmatic Brexit outcome”, a huge buying opportunity may arise for UK stocks, as the domestic economy will recover and firms will get back to business as usual. “Markets do not like uncertainty. Even with a bad outcome, even if there will be disruption, there are forces in place and institutions able to deal with it,” ventures Ms Wong.
