Allocating assets for a 'fragile equilibrium'
By Jane Davies, manager of the HSBC Global Strategy Funds & the HSBC World Selection Portfolios
The reality of today's low return world was hard to ignore in 2015. Returns were low or negative across conventional asset classes, despite the fact that the global macroeconomic data was not a disaster. Our view is that it is important for investors' asset allocation to remain dynamic and flexible, and that the key to understanding longer-term prospective asset returns is current market pricing.
Market returns have been notably negative since the start of the year. Globally, equities are down over 6%1 and the ten-year US Treasury yield has compressed around 0.20% back towards the levels seen during last year's global growth scare. Such significant market weakness at the start of the year is unusual. To understand what this means, we need to put it into some macro context.
The IMF estimates that global growth was 3.1% in 2015. Global growth should be slightly better in 2016, driven by low oil prices and an improvement in advanced and emerging economies. Contrary to the bears, we put little weight on the prospect of a US recession. While the US growth outlook seems set to soften a little and manufacturing weakness is evident, the backdrop for the consumer (falling gasoline prices, rising wages, employment growth) looks supportive for the economy at large. We also think that European cyclical momentum looks better and that investors should not be overly-pessimistic on China's macro-economic performance. Despite the well-known weakness in manufacturing, the service sector is faring better. Investors have tended to over-emphasise the importance of manufacturing and ignore the positive dynamics in services. The ongoing rebalancing of the economy means that services have been the key driver of growth in recent years. Furthermore, although the Chinese economy suffers from a debt overhang, the authorities retain substantial policy firepower from both a monetary and fiscal perspective.
Two other well-known macroeconomic themes remain important. First, it is monetary policy divergence, with the US Federal Reserve tightening and the European Central Bank and the Bank of Japan continuing to ease. Second, it is the 'slow and low' interest rate cycle, with rates reverting gradually to historically-low levels across the developed economies.
Equities: worth the risk?
Based on this outlook for the interest rate cycle (with a low growth and low inflation mix) and current market pricing, sustainable asset class returns continue to look low relative to history. Still, relative to extremely low cash rates and government bond yields, equities (as well as corporate bonds) offer reasonable risk/return potential in our view. In other words, there is an "equilibrium" of sorts, but it is fragile. Market pricing is not particularly generous in our view, and there are risks. So, at the start of 2016, macro risks permeate, market volatility is likely to be episodic (as it was in 2015), and margins of safety are limited.
That said, we think that the broad economic environment remains supportive for equities. Corporate health metrics have deteriorated a little, but slowly, and hardly to a level which we would regard as stressed. Meanwhile, profit margins remain wide, buttressed by low unit labour costs. We view the recent market volatility as excessive relative to the underlying fundamentals and macro risks. However, equity valuations are less attractive than in recent years. Within developed markets, we continue to favour Europe and Japan over the US. This is based on the relative valuation position and the profits cycle, as well as the backdrop of continued monetary easing.
Bonds: diverse prospects
The unprecedented period of quantitative easing gave core developed market government bond prices a significant boost. The market has become effectively distorted over the last few years, and that was evident again last summer, when US Treasuries failed to rally below 2% yields despite conditions turning particularly challenging.
This has led us to retain our view that developed market long-dated government bonds may be less likely to fulfil their primary role of hedging multi-asset portfolios until prices come down to more realistic levels. Poor valuations lead us to maintain our underweight position. We need to think about alternative options as "safety" lower risk asset classes. Given the current pricing, we prefer to add holdings in short-duration bonds and US TIPS (Treasury Inflation Protected Securities), alongside cash.
We have a positive view of corporate bonds across developed markets, where the reward for bearing credit risk remains attractive. We are yet to see any significant deterioration of default and credit downgrade cycles. This overall view is qualified by our cautious stance on some sectors, such as energy and commodities. We believe that European corporate bonds, supported by a more benign rate and default outlook, have potential to outperform.
Turning to emerging markets, the volatility experienced by some key local currencies has been a major issue. However, local currency emerging market bonds appear increasingly good value and their yields remain high. The outlook for hard currency emerging market debt is more problematic. We suspect there is a risk that bond spreads could move wider still, and the exposure to US duration is not attractive either at present.