As the trade war plays out, new risks come into focus
With a truce declared in the trade war, November saw markets reclaim recent highs. Yet while an influx of liquidity and a manufacturing recovery have helped allay market fears, structural pressures continue to build.
The end of November saw the MSCI All Countries World index a hair’s breadth away from its January 2018 peak and the S&P 500 pushed on to reach new all-time highs. At the same time, the narrative over the past few months has been of manufacturing recessions, inverted yield curves and lofty corporate profit expectations. How can equities continue to rise with this negative backdrop? One side of the debate has focused on how a weak manufacturing sector will ultimately lead to retrenchment and pull the consumer down, pushing the economy into recession; whereas the other side suggests supply lines will ultimately be rerouted and the eventual depletion of inventories will lead to restocking, causing manufacturing to catch up to strong consumption and allowing the cycle to continue. We are now entering the phase where we will find out which of these two occurs.
Our thesis for last year was that the trade war’s economic impact would be greater than expected. While we didn’t disagree with the medium-term impacts being modest, we thought the short-term impact would be more acute, due to the impact on corporate confidence from the increase in uncertainty and the impact of re-jigging supply lines. We also believed that, given the strong political momentum behind the trade war, it would cause equity markets to riot, bringing both sides back to the negotiation table. This eventually played out, helped in some part by thin liquidity into year-end 2018, causing the S&P 500 to fall over 9% in December alone. We used this as a buying opportunity, adding back to risk assets.
However, as 2019 rolled on, we took risk back off the table as valuations returned to being stretched and our corporate profit model indicated EPS growth below zero, while analysts were still anticipating 8% growth. Trade wars re-escalated at a worrying pace, manufacturing continued to weaken globally, and liquidity once again became a problem as the US Treasury planned to rebuild its reserves at the Fed by US$400bn, placing great strain on the USD funding market.
The repo crisis and the return to liquidity
A turning point occurred in September, after the repo crisis. When overnight repo rates jumped from below 2% to 10% intra-day, the Fed stepped in and provided significant liquidity. To put the liquidity injection into context, the 9 months of balance sheet reduction throughout 2019 was reversed in a mere 8 weeks. That was the fastest rate of change since the depths of the GFC. This influx of liquidity has helped calm markets during seasonally challenging liquidity periods and should help prevent a similar liquidity crunch to that we experienced in December 2018.
Another positive turning point occurred in November, when global manufacturing PMIs returned above 50 for the first time since May. Global manufacturing PMIs bottomed in July, 18 months after the peak in 2017, which is the typical lifecycle for manufacturing slowdowns. This change, combined with tightening of credit spreads amongst other factors, saw our global profit model tick up. So far this indicates that manufacturing has the capacity to catch up to strong consumption and tight liquidity constraints have been removed, at least for now.
Lowered return expectations highlight the value of dynamic asset allocation
This pivot back towards liquidity provision from central banks has the potential to continue to underwrite risk-seeking behaviour and extend the cycle even further, paving over the slowdown in manufacturing created by the trade war. However, the economy remains late cycle and structural pressures continue to build. Valuation measures both structurally and cyclically have resulted in our return forecasts being materially lower than our forecasts three years ago, and clearly lower than returns delivered over the last three years. With these subdued return expectations, dynamic asset allocation becomes more important in delivering to an objective based outcome.
While we still wait to see confirmation of many of these signals, we are taking this improvement in our cyclical and liquidity outlook to participate more in the potential shorter-term risk rally by investing an additional 5% into equities and 2% into diversifying assets. However, this should be seen in the context of our overall positioning, which still remains conservative at 25% growth and with interest rate duration of two years at the fund level. We believe volatility will likely remain and the potential for a recession is a key risk, as it would quickly remove the earnings support that markets will require to continue to edge higher. We therefore continue to focus on limiting volatility and drawdown, while keeping an eye on recession risk and the outlook for corporate profits.
The Schroder Real Return CPI Plus 5% strategy
The Schroder Real Return CPI + 5% strategy returned 0.96% (pre-fees) in November, taking the return for the year to November to slightly over 9%. The one year return is now well above our target of real 5%, however the three year return is still lagging its objective, due mainly to the tough environment for most asset classes in 2018. Volatility and downside risk remain low and consistent with the strategy’s objectives.
October was a strong month for most asset classes. This saw positive contributions to returns across the board. Equity positioning provided the largest contribution to performance, split relatively evenly between Australian and global. The strategy’s currency holdings added to performance, with the Australian dollar falling over the month. Our exposure to foreign currency added value. With Australian bond yields falling, the strategy’s exposure to this asset class also added to performance.
With most asset classes posting positive performances in November, there were very few negative contributors in the month. While cash holdings contributed positively to overall returns, in a strong market environment like November, even stronger returns could have been achieved had this cash been invested elsewhere.
November continued the positive trend of 2019 with equity markets rising over the month, as signs of progress towards a “phase one” trade deal between the US and China boosted sentiment. Developed markets outperformed emerging markets, with the US equity market the best performing major market over the month.
We have retained our relatively cautious view on equities. However, in the month we did add to the strategy’s exposure, taking the equity position to 25% from 20%. While valuations are problematic and expected returns over the next three years are expected to be muted, the change reflects the US Federal Reserve’s addition of liquidity into the system after the repo market disfunction.
Within equities our preferred markets are Australia and Japan, while we continue to lean against “growth” as a style factor given its stellar outperformance and increasing disconnect with fundamentals.
Improving sentiment had a negative effect on global bond markets, seeing rising government bond yields across the major economies and negative returns from government bond indices. In contrast, Australian government bond yields fell, affected by continued softness in the Australian economy.
We remain attracted to duration and are currently positioned with around two years of duration in aggregate in the portfolio. Over the medium term we do expect rates to move lower, and, if the downside risks to growth unfold, we would expect duration to be an important contributor to total returns.
With respect to credit, we maintain a neutral stance in the investment grade space, particularly in Australia where the high quality of the sector provides some low risk carry. We are a bit more cautious further down the credit curve. However, in line with equities, we added to our credit exposure in November. Both global high yield and RMBS were lifted by 1% each. We also added some more diversity into our credit holding by selling 2% out of Australian higher yielding credit and using the proceeds to add an exposure to Asian corporate credit. We have begun to make a small investment into the commercial mortgage market where bank regulatory capital changes have created an opportunity for the participation of non-bank capital providers. Reasonably high yields are still available in this space.
We believe that one of the main motivators for the RBA in cutting rates is to continue to keep the AUD as weak as possible. This should be helped by being still fair value or slightly expensive on our valuation screens. The AUD softened in November, in line with the weaker Australian economy. We continue to hold our GBP positioning, on the basis that the risk of a hard Brexit would appear to have abated, and valuations suggest that a relatively negative outcome is priced into markets.
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