A tug of war has developed between support from additional central bank liquidity, and the challenges posed by the uncertain global economic outlook. In recent weeks, markets have taken the view that the uncertainties are not systemic and that with growth remaining positive, liquidity should allow asset prices to inflate further. We think the picture is more nuanced, as we worry about risks in Europe, and believe that monetary policy may have become less effective.
We believe the current market environment is characterized by:
- lower than average global growth, but with regional variations,
- yields remaining lower for longer, and
- uncertainties creating risks of higher volatility.
These drivers create challenges as well as opportunities for investors. Overall, we maintain a prudent investment approach. However, we also recognize that the structural support provided by central banks should support credit performance. Within equities, we already have a defensive sector exposure and are underweight Europe.
Investment implications of the current market outlook:
1. Low growth requires geographical and sector differentiation:
- We prefer U.S. and Asia over other markets as growth there is more resilient.
- In Asia, we like India, Indonesia and the Philippines, due to their strong growth outlook, domestic-driven earnings profile and defensive merit. We are also overweight Singapore for its defensive earnings and attractive yield appeal. We move China to neutral from overweight and continue to focus on the structural growth themes in the New Economy sectors. In Europe, we are particularly underweight the periphery, including Italy and Spain.
- We see opportunities and structural support in infrastructure and the EM middle class.
2. Low yields for longer allow us to add to credit exposure:
- We think EM bonds should benefit from investment flows as the search for yield continues. We upgrade Brazilian local currency bonds and Indonesian corporates.
- We see opportunities in dividend stocks, good quality Tier II European bank bonds and selective global real estate.
- We upgrade USD high yield (BB and B) to a small overweight, but continue to avoid the energy sector.
3. Implications of higher volatility:
- We foresee renewed weakness of GBP and JPY strength. The former may support UK stock index performance, as multinationals benefit from translation gains, but we hedge GBP currency risk.
- We think the sharp UK gilt rally is overdone and prefer index-linked gilts. We prefer TIPS over US Treasurys as well.
- Increased uncertainty causes us to downgrade Turkish equities to neutral and its sovereign bonds to neutral with a negative bias.
Slow growth, low rates and significant uncertainties
In our view, the investment environment for the coming quarters will be characterized by slower than average global economic growth, interest rates remaining low for (even) longer than previously thought, and a high degree of political and economic uncertainty. While this may sound like a difficult investment environment, we see silver linings and opportunities for each of these three aspects.
1. Slower economic growth
The Brexit process has led our economists to cut their growth forecasts not only for 2016, but also for 2017. The biggest cuts of 0.5 percent are for the UK and the Eurozone for 2016, with growth falling to just 0.7 percent and 1 percent, respectively in 2017. This leads us to continue to adopt a defensive stance towards European equities, and we maintain an underweight position in the cyclical sectors.
Silver lining:
The U.S. should be less affected, with growth remaining at 1.9 percent, while emerging markets should still accelerate between 2016 and 2017 in our view, from 3.4 percent to 4.1 percent next year. As long as European growth remains around 1 percent and well out of recession territory, the impact of the UK slowdown is unlikely to be systemic for the rest of the world.
2. Lower interest rates for longer
As a result of slow economic growth and quantitative easing around the world, 10-year Japanese and German Bund yields are now in negative territory, while UK gilt yields have fallen to new lows (around 0.8 percent). Bank stocks have been hit by dimming prospects of rate hikes in the near future, while bond holders find it harder to achieve their target returns.
Silver lining:
We think that emerging market assets still offer an attractive pickup over developed market bonds. The search for yield by USD- or EUR-based investors is reaching into emerging markets (EM), and fund flows are supporting EM performance. In the weeks following the Brexit, EM assets were relatively resilient on the back of continued growth in EM economies, structural support for oil prices in coming quarters (even if there is short-term potential for volatility) and slower interest rate hikes in the U.S. We have become more constructive on Brazilian local currency bonds as a result of falling inflation and improved political optimism. We also upgrade Indonesian corporate bonds on expectations of an upgrade of the sovereign, and increased infrastructure spending.
Implications and opportunities:
The search for yield is likely to continue to benefit credit markets. In Europe, bond purchases of the European Central Bank have led nonfinancial corporate bond spreads to trade 0.1 percent below the average since January 2000 (1.11 percent). By comparison, senior financial bonds are trading slightly (0.1 percent) wider than the historical average (1.06 percent) and Tier II bonds are 0.7 percent wider than their average (2.54 percent). We believe that there are opportunities among good-quality European banks both in senior and Tier II bonds. As spreads tighten for non-financial corporates because of continued ECB buying, we think that financials will catch a bid as well through a process of "positive contagion" (or relative value).
Our view of slower growth and the search for yield also continues to support stocks that offer a sustainable dividend. We note, however, that many dividend yielders are found in Europe and the UK, and we would look for active diversification and a preference for the U.S. and Asia.
Real estate is an asset class that typically benefits from low interest rates. Slower growth can hurt performance, but generally, direct investments can be resilient when there is a long-term contract with a good tenant. The UK may face volatility in the short to medium term, until its position on Brexit becomes clearer, or when GBP reaches a level that makes certain assets (likely of good quality) attractive to foreign buyers. However, even in the UK, returns may remain attractive for some assets with long leases and with quality tenants. In Europe, we principally see opportunities in Germany, while the political news in the Eurozone periphery and pressure on peripheral banks keeps us from venturing outside of core Europe. A certain safe haven appeal for the U.S., and resilient growth both in the U.S. and Asia should lead to interesting opportunities there.
3. Significant uncertainty—increased volatility
The UK’s re-negotiation process with the EU is uncertain at this stage, especially as the UK government has not yet formulated what it wants to achieve.
Political risks also exist within the rest of the EU. The Italian referendum on the reform of its Senate, to be held in October, is another important risk event, with polls indicating a 50/50 chance for either outcome.
The prime minister has said he would resign if the referendum proposal does not pass, and the senate reform—a critical precondition for allowing much needed structural reforms in Italy—would probably die with it. The handling of bank recapitalization may be critical, as many households hold subordinated bank bonds; but Italy also wants to avoid taking on too much additional debt for fear of a possible rating cut.
Uncertainty is likely to result in higher risk premium and keep volatility elevated.
Silver lining:
The accommodative nature of central bank policy in Europe and Japan, and increased global fiscal stimulus are likely to keep even the EU and UK economies from falling back into recession.
Implications:
Volatility can create opportunities to add to the return potential, which is important when weak growth threatens equity market returns and low bond yields cap bond returns. We see several areas where volatility can help:
- Currencies remain very volatile, and an active strategy to take additional currency exposure, or hedge unwanted risk, can help add to performance. Currently, we believe that GBP will continue to fall against USD and EUR, with EUR also weakening against USD. We believe that recent JPY weakness is temporary and JPY will see support due to its safe haven appeal.
- We think that GBP weakness will support the UK stock market index, which is dominated by multinationals who may become more competitive due to the GBP fall, or see translation gains. As a result, we now have a neutral view on the UK stock market index. For investors, though, it is important to consider hedging currency exposure. In addition, for companies with more local business risk, we think the many uncertainties facing the UK economy may cause continued volatility.
- We think that gilt yields have undershot and yields may see an upward correction in coming weeks. Interest rates are now broadly expected to fall, and there is even a 30 percent probability priced in of rates going to zero by the end of 2017. We think markets underestimate the risk of rising inflation as a result of the weaker GBP, and we prefer index-linked gilts over conventional gilts. In the U.S., we have a similar (but milder) preference for TIPS over Treasurys, as we expect to see progressively higher wages and oil prices boosting inflation.
In summary, we think there are opportunities in a low-growth and low-yield world. Geographical choices are important as growth is likely to be resilient in the U.S. and Asia, but weak in Europe. Managing currency exposure is critical because some currencies remain volatile; they can impact returns and can also have an impact on equity market performance. In a low-yield world, we take some more credit risk, within reason. And finally, we believe that it is important to use volatility tactically, to spot opportunities where assets are oversold, or take profits where they have rallied too much. In a low-yield and low-growth world, all of these elements need to be combined to maximize the potential of generating acceptable portfolio returns.
Jose A. Rasco is the Chief Investment Strategist for HSBC Private Bank-Americas. He is a member of the Global Private Bank Investment Committee. This column is for informational purposes only. It consists of general market commentary and should not be relied upon as investment advice.
