Economic & Strategy Viewpoint
Stocks and bonds rebound after a difficult year
Sentiment has brightened, thanks in part to reassuring words from central banks, but growth remains at lower levels and political risks persist
Last year was an unusual one for investment. For only the third time since 1900, both equities and bonds delivered a return lower than cash.
Normally, when shares have a bad year, government bonds offer some respite. This was not the case last year. Concerns about US interest rates rising too far and too fast meant that investors sold both shares and bonds.
The good news is that both stock and bond markets started 2019 on a much more positive note. Both asset classes were buoyed by the soothing words from the US Federal Reserve (the Fed) on interest rates.
Major equity markets enjoyed the best start to the year in decades. Global equities, as measured by the MSCI World Index, rose approximately 8% in sterling terms in the first two months of 2019.
So what does the rest of the year hold? The forward guidance from the Fed has changed dramatically, going from expectations of further rate increases to an indication that rates will now not rise further in this cycle.
However, while still positive, the economic backdrop is less supportive than it was and there are still significant political risks to the growth outlook.
Slowdown, but no recession
Schroders recently trimmed its global growth forecast for 2019 to 2.8%, while making a small upward adjustment to its forecast for 2020 to 2.7%. This reflects a recent slowdown in activity, with global trade volumes falling sharply at the end of last year.
We may see further disappointing data as companies run down inventory built up in anticipation of increased US tariffs on Chinese goods.
However, we do not expect this Sentiment has brightened, thanks in part to reassuring words from central banks, but growth remains at lower levels and political risks persist slowdown to lead to a recession. We see a number of reasons why growth should stabilise this year and heading into 2020.
Reduced political uncertainty – but resolutions remain elusive There have been encouraging signs of progress in the US-China trade talks, and markets now expect the US president and his Chinese counterpart to announce an agreement at an upcoming summit. A deal will help support US growth in 2020, as the boost from higher fiscal spending dissipates.
However, even if a trade deal does materialise, the US and China are still at loggerheads over technology, and we may yet see a “trade war” morph into a “tech war”. Meanwhile, any Chinese agreement to buy more products from the US could lead to political tensions, with trading parties squeezed out by the new arrangement.
In the UK, at the time of publication, the range of possible Brexit outcomes remains wide. Assuming we avoid a no-deal, we envisage a modest rebound in UK business and consumer spending later in the year.
Yet it is unlikely that uncertainty around the UK’s relationship with the rest of Europe will be resolved any time soon, and we expect this to weigh on the UK’s prospects for some time to come.
Source: Schroders, Cazenove Capital
Oil and central banks lend support
The sharp fall in oil prices late last year should help support growth this year. Lower oil prices mean higher real incomes, particularly in the US, where taxation on gasoline is low.
In addition to higher consumption, rising real wages should help ease the political tensions that have been so apparent over the last few years.
The fact that central banks are less inclined to raise rates supports our thesis of stabilising growth. The prospect of higher borrowing costs was a real concern last year.
However, in January, the Fed said it would be “patient” about making changes to interest rates this year. In March, the European Central Bank followed suit and said it would keep rates at current low levels for the remainder of the year.
Reducing risk and staying diversified
Our portfolios have benefited from the rebound in global stock markets. However, equity valuations no longer look especially compelling.
Having started the year at a discount to their 15-year average valuation on a price-to-earnings basis, global equities are now back in line with this norm.
This doesn’t mean that equities can’t continue to rally. However, given we believe we are in the later stages of the business cycle, we think it makes sense to take advantage of improved valuations to gently reduce risk.
This will involve moving into less risky parts of the equity market and potentially reducing our exposure to corporate credit in favour of safer government bonds. We are also increasing holdings of assets that have historically maintained their value during adverse market conditions, such as gold and cash.
Importantly, we will ensure that our portfolios remain well diversified. This is the best way to ensure that, whatever the rest of the year brings, our portfolios should be able to deliver an attractive return without being fully exposed to any renewed volatility.
Our positioning: global and long-term
It is not often that global currency markets will move on an obscure, 415-year-old point of Parliamentary procedure. And yet this is exactly what happened in March, when the Speaker of the UK’s House of Commons invoked a 1604 precedent to stop Parliament voting for a third time on Theresa May’s withdrawal bill. The pound suffered a swift tumble as the news broke.
Given our exposure to UK assets and sterling, we have been following the twists and turns of the Brexit negotiations closely. But we are very conscious that the UK is a small island in a wide world of investment opportunities.
We still have a sizeable allocation to UK stocks, but this is meaningfully lower than it would have been, say, a decade ago. This is not because of our views on the Brexit process, or its likely impact on the UK economy, but rather a response to the distinct sectoral weightings of the UK market.
Natural resource companies account for a quarter of the FTSE 100’s market value, more than twice their weighting in developed equity markets more broadly.
On the other hand, technology is extremely underrepresented. These weightings reduce the appeal of investing in line with the UK index. While skilled active managers can still find opportunities in the UK market, its composition makes this harder.
Given its make-up, the UK market may not be positioned to benefit from technological disruption. The largest companies in the FTSE 100 have been steadily churning out profits for decades.
In contrast, some of the largest in the S&P 500 – including Alphabet (Google’s parent company), Amazon and Facebook – have risen to prominence only in the last decade. We want to ensure that our portfolios are positioned to benefit from disruption, rather than be hurt by it.
How market composition differs
One way we have done this is through thematic investments focused on technology and healthcare. Technology continues its relentless transformation of many aspects of life, with hugely promising areas, such as artificial intelligence, still in their infancy in commercial terms.
In healthcare, new technologies – as well as new drug discoveries – are delivering new forms of prevention and treatment. There are a number of other themes and geographies to which we have been making allocations.
In more traditional investments, we like inflation-linked bonds, which perform well in more inflationary environments. With unemployment at record lows in a number of developed markets, we see this as an underestimated possibility.
Lower oil prices have recently depressed headline inflation but there are some signs, such as wage growth, that underlying inflationary pressures may be starting to pick up.
We see interesting opportunities in specific markets. The Chinese equity market – both A-shares and Hong Kong – is already huge, with a capitalisation greater than all eurozone stock markets combined.
The A-share market in particular is set to benefit from increased institutional and foreign ownership, and it offers exposure to attractive areas of the Chinese economy not available via the Hong Kong market.
Finally, given our belief that we may be in the later stages of the current economic cycle, we have been gradually increasing our exposure to alternative assets that offer the safety of diversification.
These include gold and trend-following hedge funds, both of which have in the past proved able to deliver positive returns in falling equity markets.
Chief Investment Officer
Caspar Rock joined Cazenove Capital in September 2016 and is Chief Investment Officer. He joined from Architas Multi-Manager Ltd, a part of the AXA group, where he was Chief Investment Officer and responsible for all aspects of the investment activities, including investment philosophy, process and team. He also oversaw portfolio management at two of AXA group’s private banks. He previously headed up the multi-manager business at AXA Framlington from 2006 to 2008. Prior to that, he managed a range of directly invested equity and bond portfolios, and was Head of European Equities at Framlington as well as a member of the Healthcare team. He has 29 years’ investment experience.