At a moment of maximum uncertainty and with this strange cycle on the edge, 2020 may see the global economy slide into recession or avoid one altogether.
In this Q&A, John Stopford, Head of Multi Asset Income and Portfolio Manager Investec Diversified Income Fund, warns investors to be prepared for the black, the white and the grey.
HOW ARE YOU LOOKING TOWARDS 2020?
We are at the point of maximum uncertainty. We are still feeling the after-effects of policy tightening last year. We clearly have a huge amount of uncertainty, which is impacting investment and spending decisions, linked to issues ranging from the trade war between the US and China to the Hong-Kong riots and Brexit. But some of these issues are showing some slightly more positive signs at the margin and, clearly, policy has been eased significantly.
The question now is: will the consumer and services and the labour market hold up long enough for policy easing and the other more positive dynamics to play out, or are they essentially already cracking under the weight of weak manufacturing, weak trade and, weak investment? Are we actually already sliding into recession?
SO, IT’S BETWEEN WEAK MANUFACTURING SIGNALS OR ROBUST CONSUMER AND LABOUR SECTOR SIGNALS?
It has been an interesting cycle. The labour market is linked to business, because if businesses are struggling, they don’t hire, they fire. It is the same with wages. The labour market is bending, weakening but not yet breaking. If it can continue to hold up, then those more positive dynamics can play out, but it is on the edge. Many of the indicators that we look at which tend to anticipate changes in the unemployment rate, more than half of those are looking quite weak and quite threatening, but not yet decisively so and one or two of them are still looking pretty robust.
We are on the edge. We - hopefully and probably - will avoid sliding into recession but it is at the point of maximum uncertainty now. It will be a few months at least before we have greater clarity although, clearly, the equity market is hopeful and maybe the bond market is telling us the reverse; it is fearful.
WHAT ARE THE RISKS AND OPPORTUNITIES YOU SEE IN 2020?
If we get the all clear, I think the big opportunity is for some rotation. It is an unusual cycle in that normally with most cycles recently the US economy has led and it has been Europe and Asia that have followed to some extent. This time around, because the epicentre of the slowdown has been in manufacturing and trade, which is what Europe and Asia are good at. If we get an inflection point there, it’s those economies, those industries that are going to do well.
If we avoid recession and have a soft landing and recovery, there is an opportunity for repricing of more cyclical assets, non-US assets, and to some extent probably financials as well. In those circumstances, people will begin to review price expectations and monetary policy. This means bond yields will rise and yield curves might steepen a bit simply because the bond market at the moment is trying to weigh up the odds of further rate cuts from the US Federal Reserve. Is the economy weak, or have the Fed’s actions been a stitch in time? The Fed has cut three times, which is a typical mid-cycle or late cycle insurance cut or set of cuts. It may not need to do more if the economy soft-lands and ultimately recovers.
HOW DO YOU PREPARE FOR SUCH BINARY OUTCOMES IN 2020?
These two outcomes need a different approach: one way to hedge your bets is to own options. Options give a skewed pay-off. They allow participation in one direction but not the other, so to the upside and not to the downside. There is a cost involved in that but now that cost is not expensive. Given the level of uncertainty, the pricing of options, particularly in things like the equity market, looks cheap to us.
It is important to be properly diversified and to run a lower level of risk than normal. We need to look for those opportunities in markets that are already pricing in a lot of bad news. This means some of the more cyclical parts of the market and opportunities in equities outside the US, potentially in financials. There are more opportunities in equities than in other growth-related assets, such as credit. Even if the cycle extends, it is still too late in the cycle to get excited by assets such as high yield.
The other thing that is beginning to happen is a slight turn in the dollar. The ‘exceptionalism’ of the US, where the US has outperformed on a serial basis and the Fed has been one of the few central banks able to tighten policy, is changing. The US is now weakening relative to the rest of the world, particularly if we get a soft landing. Also, the Fed is now easing policy potentially more aggressively than other central banks are because they have less scope to. We are not looking for significant dollar weakness, but the sort of persistent dollar strength which has been a problem for the rest of the world is showing signs of fading.
• We are at the point of maximum uncertainty, but we still need to generate outcomes for our clients, so we are preparing for the black, the white and the grey.
• We are on the edge of this strange cycle. Will the consumer and labour markets hold up enough for policy easing to work, or will the economy crack under the weight of weak manufacturing and trade leading to a recession?
• If we get the all clear, the big opportunity is for some rotation. If the opposite, investors need to hedge their bets properly which means options, true diversification and having a fundamental understanding that the drivers of investments have shifted from last time – the demise of the dollar is one major trend to watch.
All investments carry the risk of capital loss.
Article taken from Hub News Issue 44.
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