Risk/reward tradeoff growing less attractive
Three of the key market trends of the past 18 months – a strong dollar, falling commodity prices and serial poor performance by emerging markets – all went into reverse during the first quarter of 2016.
It’s too soon to say whether this will last. Emerging markets still have work to do improving their economic fundamentals, and the dollar could strengthen again later in the year, if investors revise up their expectations for rate increases in the US. But for active investors, it’s probably a risky time to be underweight EM.
With growth worries lingering on both sides of the Atlantic and the corporate earnings picture still subdued, the trade off between risk and reward is much less attractive now than in earlier stages of the cycle, at least for equities.
The case for riskier parts of the fixed income market looks stronger, given that many of these bonds are now priced for a recession that we do not think is imminent. But overall, it probably makes sense for investors to have a more balanced portfolio than in earlier stages of the bull market and to lower their expectations for overall returns.
The risks we worry most about are weakening service sector activity in the US and Europe, bond market turbulence around changing US inflation and interest rate expectations, and Brexit.
Key considerations for investors this quarter include:
- A reprieve from central banks – and different focus for investor concern: Investors started the year worried about falling markets in China, further falls in the oil price and a potentially premature rate rise by the Fed. Now the concerns are slowing consumption growth in the US and Europe and rising core inflation in the US.
- Uphill battle for returns bolsters the case for adding alternatives: Continued record low bond yields and a maturing equity bull market are keeping the prospective returns on traditional assets low, making it a good time for investors to explore less correlated sources of return.
- Brexit and beyond – political risk is creating a ‘wait and see mode’: Uncertainty around the upcoming EU referendum has already had an impact on UK corporate investment, the value of the currency and short term market interest rates. A vote to leave the EU could halve the growth rate over the next year and have a noticeable effect on activity in Europe.
- Markets are from Mars, economies are from Venus: Equity markets have become disconnected from the performance of the economy recently, with main indices in the US and Europe disproportionately damaged by bad news from manufacturing and energy and slow to benefit from consumer-led growth. This may be about to change but it’s a cautionary tale for index-based investors.
1. Another reprieve from central banks – and a new focus for investor concerns
We expected 2016 to be another challenging year for investors, with higher market volatility and lower returns. We have certainly seen that in the first few months of the year, when markets have been rocked by global growth fears and dramatic swings in oil prices, plus an outbreak of concern about the waning potency of central banks.
The net result of all this drama for investors who simply held on to a standard 50/50 portfolio of bond and equities was not dramatic at all.
Such a portfolio would be showing a total return of just over 2% year to date. It is quite possible that 2016 will deliver more of the same, with much ado in markets leading to not very much—in either direction—for a broadly balanced portfolio.
However, the focus of investor attention has shifted since January. While it was previously manufacturing weakness that was causing concern, now it is the recent softening in services and consumer spending that is causing concern.
We don’t think that a recession is imminent on either side of the Atlantic. But clearly the risk is higher than it was a year or so ago and we will be monitoring the consumer side of the economy closely for signs that the recent weakening in activity doesn’t turn into anything worse.
Central banks came to the rescue yet again in the first quarter, with ECB action on a broad front helping to push down interest rates right across the curve and reassuring markets that they had not run out of fire power.
But forecasters around the developed world are yet again revising down their growth forecasts for 2016, despite more than 6 years of extraordinary monetary stimulus.
Policy makers and investors are having to accept that there are deeper issues holding back global growth and investment at the moment which central banks alone cannot fix.
2. Uphill battle for returns bolsters the case for adding alternatives
In a world where core fixed income yields remain incredibly low, equities are no longer cheap and global growth remains mediocre, it can be hard for investors to know where to turn. Making matters worse, the yield cushion on government bonds has deteriorated, making them not only unlikely to render significant further capital gains, but also more vulnerable to inflationary surprises.
Equities still offer an attractive income alternative to bonds, with their average dividend yield significantly higher than 10 year government bond yields.
But the upside potential of these assets is lower than it was, given that valuations are already close to long-term averages in many countries.
A typical balanced portfolio has largely rewarded investors with positive returns in the years since the financial crisis, and did help to protect investors from the market storms at the start of this year. But the evidence suggests that traditional market beta is less likely to deliver going forward, intensifying the search for sources of alpha – and strategies which are not as reliant on a positive correlation with bonds or equities.
If you consider the classic trinity of investment goals – return, income generation and risk management – today’s low-yield environment presents challenges on all three counts.
It is all but inevitable that investors will push into higher yielding assets in search of income, which can add risk to portfolios. In this context, liquid alternative strategies tapping into less correlated sources of return to achieve higher risk-adjusted returns have significant attractions.
These strategies can also help add diversification by incorporating downside protection.
3. Brexit and beyond – political risk is creating a ‘wait and see mode’
With the EU referendum looming in June, it may be difficult for UK investors to focus on much beside Brexit risk. There has already been a sharp decline in the sterling/ euro exchange rate since the start of 2016, and some planned investment in the UK by domestic and foreign business has probably been delayed.
We anticipate a vote to remain in the EU, but the result will depend heavily on the turnout and the risks of a Brexit have risen since the vote was announced. If the UK does vote to leave, the long-term consequences are possibly overstated – by both sides of the debate. But the short and medium term outlook could be very messy indeed.
Rather than growing at about 2% a year the UK would probably only manage about 1% growth for a few years, as uncertainty around the eventual outcome of negotiations about the UK’s future relationship with the EU may discourage or delay investment and trade. Other things equal, this would mean interest rates would go up less quickly and sterling would fall, perhaps quite significantly.
Longer term, the microeconomic impact of a Brexit will be more important than the macro, with investors needing to consider carefully how individual sectors and companies are positioned for the new environment. But the uncertainties around Britain’s future relationship with the EU would not be quickly resolved, and the slowdown in investment at the end of 2015 underscores that this is a poor time to be giving businesses something else to worry about.
4. Markets are from Venus, economies are from Mars
The chart below shows the exposure of regional economies and equity markets to international demand, consumption, manufacturing and production. A clear message is that the main regional equity markets in both the US and Europe are much more dependent than the domestic economies on the commodity and manufacturing sectors.
With energy and mining firms contributing 20% of profits in Europe and 10% in the US, it should not be a surprise that falling commodity prices have seen equity markets suffer. The market’s much heavier reliance on the manufacturing sector has also taken its toll on corporate profits.
As well as being heavily exposed to negative economic stories, the US and European equity markets are also relatively underexposed to improving factors. In both regions, a healthy consumer has helped to support economic growth over the last few years. However, the two equity markets source a relatively small proportion of their profits from domestic consumers, meaning equities don’t feel the full benefit of healthier consumption.
European earnings growth has struggled over the last two years, but this has not been a broad-based story. In fact European equities with little exposure to the dollar and heavy exposure to the domestic economy have registered double-digit earnings growth in 2015.
Active management can help to protect a portfolio from the negative factors and position investors to benefit from the positive.
Stephanie Flanders is chief market strategist for Europe, JP Morgan Asset Management, and David Stubbs and Michael Bell are global market strategists