A glance at the geopolitical headlines today leaves one despairing for the state of the global economy. An escalation of protectionist rhetoric from the US, unresolved Brexit negotiations, slowing growth in China and fault lines re-emerging in the eurozone – all are weighing heavily on the outlook. That said, their tangible impact on economic activity has thus far been modest. The IMF still projects the world economy will grow at an above-trend 3.9% this year and next. The US is presently leading the pack with an extraordinary acceleration to what might well top 4% (annualised) in the second quarter as tax cuts, fiscal spending and a pro-business regulatory agenda lead to a corporate investment renaissance. True, the quality of the US growth is somewhat suspect (is it wise after nine years of economic expansion to add even more fiscal fuel to the fire?) but the results to date are extraordinary – US small business optimism, for example, is at its highest level since 1983.
The contrast between the geopolitical drama played out on our screens (and on social media), and the relatively benign state of the economy is reflected in financial markets. Despite the political headlines, most asset classes have in fact been reassuringly dull in 2018. For a sterling-based investor, UK and global equities, gilts and even gold all delivered returns of close to zero during the first half of 2018 with only a modest uptick in volatility. There have inevitably been a few outliers, but these are the usual suspects – financially fragile emerging equity markets such as Argentina and Turkey have shed over 25% in GBP terms, while bitcoin has fallen around 75% from peak to trough as the cryptocurrency bubble has burst. Of somewhat greater concern is the decline in Chinese onshore listed equities, or “A-shares”, down around 12% in H1 in GBP terms as domestic growth slows, weighed down by financial deleveraging and escalating trade tensions.
Lower returns appear inevitable as central banks progressively withdraw liquidity…
The shallowness of market returns in 2018 should come as little surprise to investors after two years of extremely strong asset price growth. Steady increases in US interest rates and the conclusion of the European Central Bank’s bond purchase programme, currently planned for December of this year, mark the beginning of the end of easy money and this will inevitably be felt in asset values. Equity market multiples are already beginning to contract profits rise without a share price follow-through, trend higher while more speculative assets will continue to correct, in some cases quite materially.
For these reasons, we have already begun to reflect a more cautious stance across our portfolios. Since late last year we have been moving underweight in our equity allocation, deploying portfolio insurance where appropriate and trimming holdings of high-performing growth stocks. At the same time we have reduced our allocation to lower-grade credit funds. In short, a gradual but steady de-risking in our balanced funds and a gradual move to more defensive stock selection across our equity mandates.
So what has happened to the traditional safe havens?
Having painted an investment picture of relatively low returns in coming years (albeit with low volatility), what are the risks of something more dramatic? Thankfully, the traditional threats of economic recession, ‘unanchored’ inflation or excessive leverage do not appear imminent, rather it is the absence of places to hide that worries us – in short, most of the traditional safe havens seem to have rather big question marks hanging over them:
- The most damaged are probably bond markets which, after years of central bank distortion, offer some of the lowest levels of inflation protection in a generation. A 10-year gilt offers a real yield of minus 1% today, just as renewed sterling currency weakness deriving from the tortuous Brexit threatens the recent moderation of UK inflation. In Germany, despite 2%+ GDP growth (well above the long-term trend) the 10-year Bund now delivers a real yield of an extraordinary minus 1.8%. US Treasuries do now offer positive real yields but unfavourable supply and demand dynamics undermine their safe haven value: an avalanche of bond issuance will be required in coming years to fund President Trump’s tax cuts and public spending pledges, just as the Federal Reserve is retreating as a major buyer of bonds and actively shrinking the mountain of Treasury holdings it built up during the era of quantitative easing.
- Brexit continues to cloud the outlook for gilts and for sterling assets in general. Our base case is a ‘soft exit’, with multi-year transition arrangements and probably an extended membership of at least the Customs Union. We recently visited Brussels, where, among others, we met with the European Commission. While their outlook was broadly optimistic, they had clearly also reached an advanced stage in their planning for a ‘no deal’ outcome – more so than we had expected. In the UK, some preparations have also been made – in their June Stability Report, the Bank of England made clear that the UK banking system had adequate reserves to support the real economy through a disorderly exit, emphasising that the levels of household and corporate debt to income are well below 2008 levels. Nevertheless, the economic risks of a ‘no deal’ are clearly material. Against this backdrop there is an abnormal degree of uncertainty in traditional safe haven UK assets including commercial and residential property, and of course sterling.
- Tellingly, the market sell-off we saw in early February this year triggered a brief but sharp rise in volatility across all major assets classes. During that phase, portfolio diversification was of little help – government bonds, credit, equities and most alternatives all fell simultaneously. This suggests that as central banks gradually tighten, asset prices that rose together in the up-cycle could now fall together if we see a down-cycle. In other words, the traditional safe haven provided by asset diversification may be challenged as today’s liquidity support is slowly withdrawn.
So how should investors react?
With question marks hanging over many of the traditional safe havens, we are first of all holding higher cash balances across our balanced funds. This not only affords us portfolio protection but also provides us with ‘dry powder’ to opportunistically buy into any excessive correction in asset markets. Secondly, we are cautiously minded to add to euro currency exposure in light of recent weakness, given the sizeable trade surpluses and falling government deficits observed across the eurozone in the medium-term. We also regard a weaker US dollar as essential in achieving the decline in the US trade deficit sought by the present administration.
Thirdly, despite the recent outperformance of low yielding technology and growth stocks, company dividend increases have been exceptionally strong. These flows will be further enhanced by the results of last month’s Federal Reserve stress tests, which pave the way for a record haul of around $170 billion in dividends from US banks. We find the combination of yield today and income growth tomorrow compelling, versus almost any other asset class.
Finally, our thematic equity managers describe in the rest of this report some of the extraordinary long-term growth opportunities they are currently analysing. Multi-year earnings growth arising from genuine secular global trends are arguably the ultimate investment safe haven from the vicissitudes of the global economic cycle.