Macro Quarterly Macro matters

Late-cycle volatility and the broad array of macro thematic market drivers present a compelling tactical asset allocation opportunity set. In this issue of Macro Quarterly we explore opportunities we see across asset classes globally.

14 Mar 2019

Calm after the storm – or before a new one? After the volatility of late 2018, 2019 has proven much kinder to global risk assets thus far. Ironically, in our view it was precisely the severity of market concerns about US monetary policy and the US/China trade war in late 2018 that has since helped to forge more benign narratives on both key issues.

But from a multi asset perspective perhaps the most interesting development of 2019 so far has been the surge in risk assets alongside the stable performance of developed world nominal government bonds. If stronger growth expectations are supporting global equities, then shouldn't longer-dated nominal government bond yields be rising and yield curves steepening?

In our view, there is not necessarily something fundamentally contradictory in these developments. The reversal of fortunes in risk assets has come despite generally disappointing macro data across Europe, the US and China and, in aggregate, downgrades to forward corporate earnings expectations globally. In short, the rally in global equities in 2019 has not been driven by expectations for a better growth and inflation backdrop for corporate profits at all. Instead it has been driven by investors' clear belief that the near 30% derating in global equity PE ratios from end-January to end-December in 2018 was at least partly overdone, given that a number of major fears have now been at least partly allayed.

Whether investors' confidence to pay a higher price for lower earnings is warranted or sustainable are clearly key questions for the outlook for global equities for the remainder of 2019. We came into the year with a positive view on global equities after the Q4 sell off. We remain constructive. But the speed and scale of the rally in 2019 to-date has tempered to a degree the conviction of that positive view. Up 11.1% over the course of January and February, the MSCI World (USD) already delivered an above-average annual return in two short months. The likelihood of material further upside for risk assets in the short-term is, in our view, now dependent on the ability of ex-US demand growth to accelerate from current weak levels and on policymakers allowing financial conditions to remain loose. In particular, the effectiveness of the broad array of measures progressed by the Chinese authorities to cushion their growth slowdown remains critical.

Our base case is that overall global equity returns in the medium-term are likely to be positive but more muted than investors have been used to for most of the post-financial crisis period. Nonetheless, continued late cycle volatility and the broad array of macro thematic market drivers are making for a compelling tactical asset allocation opportunity set. In this issue of Macro Quarterly we explore in more detail those themes and the individual opportunities across asset classes globally.

Theme: Global growth around trend

The outlook for global growth momentum remains a key driver of asset classes. After the robust and synchronized growth of 2017, the rate of acceleration in global economic growth has moderated quite significantly over the past year. The major driver of the slowdown was the lagged impact of tightening financial conditions globally, but particularly in China, and as trade tensions impact business sentiment and investment.

Milestones

Theme supportive

Theme supportive

Theme challenges

Theme challenges

Theme supportive

Global PMIs begin to steady in coming months

Theme challenges

Global PMIs decline further towards 50, separating expansion from contraction

Theme supportive

Labor markets remain solid, boosting consumer confidence and spending

Theme challenges

US Recession Tracker probabilities rise (currently at 25% chance of US recession over next 12 months)

Theme supportive

Fiscal policy supportive in countries/regions with low public debt

Theme challenges

Trade tensions escalate creating additional uncertainty and aggravating the recent slowdown

Theme case study: Long local currency emerging markets debt

With real effective exchange rates for emerging market currencies close to all time lows, global inflation falling and the Fed unlikely to tighten in the near-term, we are constructive on emerging market local currency debt.

Theme: Central banks to extend the cycle

In our view, one of the principal drivers to the sell-off in risk assets in the latter part of 2018 was the fear of a policy mistake by the Federal Reserve and by the unexpectedly hawkish rhetoric of key Fed officials.

But with inflation well contained, major central banks across the developed world can be patient in normalizing monetary policy. In particular, after the communication issues in 2018, a strikingly more dovish and growth supportive Fed narrative has emerged in 2019. While we always believed that the pace of policy normalization would be slow, recent central bank announcements suggest that is likely to be even more gradual than we had previously forecast.

Milestones

Theme supportive

Theme supportive

Theme challenges

Theme challenges

Theme supportive

Core inflation momentum remains contained despite tight labor markets and wages moving moderately higher

Theme challenges

Core inflation accelerates

Theme supportive

Growth and inflation expectations rise, supporting steeper yield curves

Theme challenges

The yield curve bear flattens

Theme supportive

Central banks remain on hold through H1 2019, and only resume tightening when growth and particularly core inflation pick up

Theme challenges

Central banks telegraph near-term tightening in the absence of clearly stronger economic and inflation data

Theme case study: Long 10y US breakeven

As the difference between nominal US Treasury Yield and 'Real' or, inflation-adjusted, yields, the so-called 'breakeven' rate represents an effective play on inflation expectations. After the significantly more dovish tone from the US Federal Reserve's rate-setting Federal Open Markets Committee in January our conviction levels have risen that market expectations for US inflation are too low.

Theme: China to find a cyclical bottom

Over the past year, the Chinese authorities have used a broad range of monetary, fiscal and regulatory stimulus measures to try and cushion the growth slowdown prompted by deleveraging initiatives and tighter financial sector regulation. To-date, those stimulus initiatives have not had the desired effect as a double whammy of sluggish domestic demand and a weak external environment for Chinese exports have continued to weigh on growth.

But we believe China will find a cyclical bottom in coming months as previous measures begin to have a positive effect, as more sizeable stimulus measures emerge, as the impact of US tariffs diminishes and as consumption growth stabilizes.

Milestones

Theme supportive

Theme supportive

Theme challenges

Theme challenges

Theme supportive

PBoC announces further RRR cuts in and lowers 7d repo rate

Theme challenges

No further monetary easing in the next 3 months

Theme supportive

Policymakers confirm continued emphasis on growth stabilization and a pause in deleveraging

Theme challenges

Fiscal measures significantly fall short of expectations and regulators stress control on shadow credit

Theme supportive

Trade tensions between the US and China continue to heal with no tariff escalation

Theme challenges

Trade tensions reach an impasse, resulting in a rise in tariffs

Theme case study: Long China H equities vs Taiwan equities

Chinese stocks and the RMB responded more negatively to the threat of a protected US/China trade war than their Taiwanese counterparts in 2018, despite Taiwan's very obvious sensitivity to Chinese growth in general as a major source of unfinished goods, and the importance of the global tech cycle to Taiwan's heavyweight semi-conductor manufacturing sector.

Theme: Higher volatility regime to stay

After the significant drawdowns and large price swings in risk assets of late 2018, realized volatility has dropped sharply across equity markets in 2019, driven in the main by progress on US/China trade and by the Federal Reserve's more dovish rhetoric regarding both further interest rates rises in the US and the reversal of its quantitative easing program.

But despite this welcome hiatus, in broad terms we expect volatility to remain above post-crisis averages for the majority of 2019 as the lagged impact of US rate hikes feeds through. Historically, the initiation of a Fed tightening cycle leads a rise in volatility by around 2 to 2.5 years. Geopolitical risks remain elevated – with the Brexit outcome still uncertain, upcoming elections in the European Union, and the leadup to the US 2020 presidential election campaign just a few of the major political events that are likely to impact markets.

Milestones

Theme supportive

Theme supportive

Theme challenges

Theme challenges

Theme supportive

Short term rate markets price in more tightening from the Fed

Theme challenges

The Fed lets the economy run hot, allowing inflation to overshoot before resuming its tightening cycle

Theme supportive

Macroeconomic volatility picks up, either via greater fluctuations in growth or inflation

Theme challenges

Growth and inflation remain moderate

Theme supportive

Global growth remains imbalanced, leading to USD strength

Theme challenges

Global growth re-synchronizes, placing downward pressure on USD

Theme case study: Long Japanese yen vs US dollar

Our long position in the Japanese Yen against the US dollar is a play on a number of key themes impacting markets. In our view, the valuation case for the trade is compelling. On our proprietary estimates of fair value, the JPY is some 20% undervalued against the USD.

Theme: Geopolitics and protectionism

Does apparent progress on the trade talks between the US and China negate the likely influence of geopolitical risk across markets over the medium-term? Not in our view. While recent rhetoric between the two giants of the global economy has been notably more constructive in the wake of the investor concerns in late 2018, behind the short-term rapprochement lie deep-seated issues regarding geopolitical influence, national security and technology intellectual property. In our view, these are very unlikely to be completely resolved in the short-term, even if US tariffs on Chinese goods are lifted.

If recent polls across Europe ahead of May's European Union elections are accurate, nor are the forces of protectionism and populism likely to abate any time soon. We therefore see heightened geopolitical risks as a trend that is likely to impact multiple asset classes for the foreseeable future. The EU elections, Brexit, and US elections in 2020 all have the potential to impact markets.

Milestones

Theme supportive

Theme supportive

Theme challenges

Theme challenges

Theme supportive

Further escalation of tensions between the US and its allies vs China. Broadening of anti-trade measures beyond goods towards investment and IT restrictions

Theme challenges

US-China trade truce

Theme supportive

Trump administration places tariffs on auto imports

Theme challenges

Trump administration backs away from auto tariffs; broader trade agreements achieved with US allies

Theme supportive

Populists gain enough share of seats in European Parliament election to influence fiscal/immigration policy

Theme challenges

Pro-EU politicians maintain sufficient power to maintain existing policies and continue with EU reform

Theme supportive

No deal Brexit

Theme challenges

UK passes Prime Minister May's plan or something similar

Theme case study: Short AUD vs USD

The Australian Dollar is widely viewed by investors as a global demand bellwether. Yet with its close ties to Chinese domestic demand, the AUD remains caught in the crossfire of the US/China stand-off on trade. With recent headlines reporting that China is considering banning Australian thermal coal imports in response to the exclusion of Chinese telecoms giant Huawei from Australia's mobile telecoms infrastructure, geopolitical tensions are now directly impacting Australian growth prospects.

Our base case is that the Chinese economy will bottom in the second half of 2019 as stimulus measures kick in and improved trade relations allow for a recovery in business confidence. But our negative stance on the AUD represents, in our view, an effective hedge against any escalation of trade tensions or the failure of China policy to support ex-US growth in the way that we expect.

Video: Global growth, inflation and asset class outlook

Evan Brown, Head of Macro Asset Allocation Strategy, Investment Solutions, gives a brief overview of the global growth and inflation backdrop and his views on asset class attractiveness and risks over the coming months.

Podcast: A complex but opportunity-rich environment for investors

For multi asset investors, we believe the big picture backdrop to markets remains equally as complex and opportunity-rich for investors. This new quarterly podcast examines the current global macroeconomic outlook and the major factors driving returns. Evan Brown, our Head of Macro Asset Allocation Strategy, takes a quick look across the asset classes and highlights where we believe opportunities can be found today.

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