After a sharp sell-off caught investors by surprise in the fourth quarter of last year, the first half of 2019 has seen a welcome rebound. But can this run continue, what macro shocks could be on the cards for the next six months, and how should investors position themselves?
Inflation Shock?
HSBC Global Asset Management’s global chief strategist Joseph Little points to inflation as one neglected risk that could cause instability for investors if there is an unexpected rise. At the latest reading, UK Consumer Prices Index (CPI) inflation rose 2% in June from a year ago, in line with the Bank of England’s 2% target. He says: “We don’t expect inflation to increase significantly in the near term, but it wouldn’t take much of an upward surprise in inflation or interest rates to change the current pricing in fixed income assets, such as bonds.”.
Slowing Growth or Recessionary Threat?
Another macro issue Little flags is the slowdown in global growth, which he thinks is unduly worrying investors. The International Monetary Fund (IMF) predicts the global economy will grow at 3.3% this year, a downgrade from its January prediction of 3.5%. This would be the weakest rate of growth since the depths of the financial crisis in 2009 when the global economy contracted.
“Investors remain anxious about global growth and the risk of a recession, but we believe these worries are excessive," says Little. "A combination of reasonable global growth, solid corporate fundamentals and supportive monetary policy means that the prospect of a recession looks more like a risk for 2021 or beyond.”
Rathbones’ head of asset allocation research Ed Smith is expecting to see a slight acceleration in global growth this year, although it will still be lower than 2018. “The low point in global growth may be behind us,” he suggests.
Time to Move Defensive?
Smith thinks the current growth environment merits a defensive stance in portfolios but shouldn’t panic investors: “A broad range of economic indicators have fallen to indisputably weaker levels than at any time since the 2008 global financial crisis." For example, he points out, US industrial production is contracting quarter-on-quarter. But that doesn't necessarily infer that a recession is on the horizon. "A mild contraction in many of these indicators is not actually unusual," he adds.
Also taking a defensive position is JP Morgan Asset Management’s chief market strategist for EMEA, Karen Ward. She points to political upheaval in the US, notably trade tariffs, which could threaten the outlook for US corporate investment. It could also potentially dampen economic growth in Europe if certain industries there, such as car makers, are also hit with tariffs.
Asset Classes for the Second Half
Against this backdrop, which asset classes should investors focus on for the rest of the year?
Ward notes that investors have historically benefited from reducing risk in their portfolios towards the end of the economic cycle, swapping equities for fixed income and cash. But, because central banks have failed to normalise interest rates during this cycle, “this makes it much harder for investors to seek shelter and wait out any storm while maintaining any kind of decent return". It is also less clear that domestic bonds and cash will play their usual role diversification for European investors, she adds.
“It seems to make sense to maintain a defensive equity allocation for now, while looking to alternatives such as macro funds and real assets to provide a potential portfolio cushion,” says Ward, pointing to real estate and infrastructure as potential examples of assets in which to invest. Within equities, she suggests investors go for value over growth and large-cap over small.
Rathbones’ Smith has been positioning portfolios defensively in equity markets since September last year, but still prefers “boring” quality stocks over bonds. Although he notes the traditional defensive sectors like pharma, food and beverage, utilities and telecoms look expensive, this does not blunt their effectiveness in market downturns, and they may start to outperform so could still be worth paying for in a maturing economic cycle.
He explains: “Despite their boringness, these assets generate market-beating returns year after year – we’ve had 20 years now where these stocks have continuously outperformed. We think that’s a good place to be at the moment as growth is likely to be less than last year and to guard against of the tail risks from the US/China trade war.”
Will Emerging Markets Outperform?
Little has tipped emerging markets to be the best performing asset classes for the rest of the year, especially EM debt. He says: “Growth in emerging economies seems to be recovering, led by improvements in China. A number of EM asset classes are relatively attractively priced and have the potential to outperform."
As well as potential outperformance, emerging market bonds might offer better value than some other types of fixed income, he adds: “Our analysis suggests investors are not being rewarded for their exposure to interest rate risks in several sectors of the bond market. In our view, emerging market government debt and Asian corporate higher risk bonds offer the best value.”
In general, global equities should serve investors well as the global economy stabilises and supports companies’ revenue growth, he suggests. But he also warns it could be a bumpy ride, and investors should expect more episodes of volatility for the rest of this year and into the next.
