Portfolio Positioning for a Multi-Low Environment

A low growth, low inflation, low interest rate environment implies tilts towards U.S., Asia Pacific and emerging market equities

Andy Brunner, 8 December, 2011 | 4:49PM

Economic & Financial Market Background
While global growth forecasts for 2011 have stabilised, those for next year continue to tumble. Global leading indicators all point to a weaker outlook for next year with growth in world trade forecast by the OECD to drop below 5% from nearly 7% this year. Global PMIs indicate a manufacturing sector continuing to downshift although somewhat surprisingly the latest service sector activity report showed a modest rise. Obviously, there are wide variations across regions and countries but lowered forecasts are not just the preserve of the eurozone; all the other main regions, with the exception of the key U.S. economy, have experienced further cuts. This can be seen in the table below, which shows the trend in individual area GDP growth forecasts over the past few months (earlier figures taken from the October and November Global Investment Strategy notes).

Along with reduced GDP forecasts in most of the main OECD countries, growth is also softening in the developing world. So far, estimates have generally only recorded modest downward revisions but there is little doubt that risks to them have risen.

It was interesting to note that the OECD in its latest bi-annual Economic Outlook placed the blame for stalling world growth at the door of eurozone policy makers. Along with those of most other commentators, OECD forecasts still assume that the EU sovereign debt and banking sector crises will be contained, but ominously warned that "alternative scenarios are possible, and may be even more likely than the baseline…. (and)…. in view of the great uncertainty policy makers now confront, they must be prepared to face the worst". In summary, a failure to restore confidence in the eurozone and/or excessively tight fiscal policy in the U.S. are noted as key risks that could lead to a far gloomier outcome for the global economy.

Fortunately for global growth, U.S. activity has recovered well from its oil price/supply chain-induced first half slowdown. Underlying private sector demand growth during that period was far higher than suggested by the headline GDP figure and, even though Q3 was revised down to 2.0% from 2.5%, private sector final domestic demand still contributed a very solid 3.1% to the total. Forecasts for Q4 have recently crept upwards with a continuing stream of data exceeding expectations leading to the Citigroup US Economic Surprise Index rising to close to an all-time peak.

The recent faster pace of growth is welcome news but partly reflects recovery from prior temporary weakness and, relative to what is needed to sustainably reduce unemployment while allowing for fiscal consolidation, it is still inadequate. Forecasting into the New Year is also exceedingly difficult as there is still considerable uncertainty over the extent of U.S. fiscal tightening next year (tax cut/unemployment benefit extension?) and the outlook is for a relatively subdued expansion phase at best.

As is evident from the previous table, eurozone GDP forecasts continue to be slashed. In reality, the likely outcome is a complete unknown but the escalation of the sovereign debt crisis, now encompassing "core" countries, has already led to a high probability of the region's economy falling into recession in Q4 and the main arguments revolve around just how deep a recession unfolds next year. Confidence-building action by the EU authorities is urgently needed and, over the next week, the latest attempt to resolve the crisis will be outlined. Whether it will be an improvement on previous "comprehensive" plans can but be hoped for although experience has shown the difficulty of producing a credible package that effectively stabilises financial markets.

As noted above, economies are also slowing elsewhere, with the details of the U.K. Q3 GDP report undermining the headline 2.0% p.a. growth rate. Real household expenditure (62% of GDP) contracted for a fifth consecutive quarter while recent forecast revisions by the Office for Budget Responsibility, accompanying the Chancellor's Autumn Statement, indicate the government's fiscal targets slipping by two years. At least one negative quarter of GDP growth appears in store in the near future and the U.K. economy may, at best, only just avoid slipping back into recession.

Activity in the Far East is also easing with slowing export growth affecting much of the region. Japan has ended its 'V'-shaped GDP rebound--plus 6% in Q3--but will benefit from reconstruction spending next year, while the authorities in China are already beginning to fine tune monetary policy following recent PMI weakness and an on-going slowdown in the property sector. China and other Asian economies, along with a contained eurozone crisis, are key to global growth prospects next year.

Monetary policy continues to be eased to help offset fiscal tightening with an extension to unconventional measures likely through next year in the U.S., U.K. and Japan, and potentially even beginning in the eurozone. With the EU banking system under severe funding pressures global central banks recently coordinated a reduction in dollar funding costs, generating a strong rally across financial markets that had earlier experienced sizeable downturns in most bond and equity markets.

Both Italian and Spanish bonds reversed much of the prior rise in yields, to what were unsustainable levels, while the recent rapid widening in the spread of French bonds over German bunds unwound completely. This partially reflected a rise in German yields, however, following a disappointing auction and growing concern over bunds' safe haven appeal. The only safe haven bond markets with adequate liquidity, at least for now, appear to be the U.S. and U.K.

Equity markets also recovered strongly late in the month as hopes rose that the December 9 meeting of EU leaders would deliver a sufficiently credible agreement to alleviate pressures on financial markets. U.S. equities led the way once again benefiting from continuing upgrades to earnings that by year will be at record levels.

Other risk assets tended to perform in line with equity trends, with strong late month recoveries in oil and copper prices. In the currency markets the euro/dollar rate also remained highly correlated to "risk on, risk off" trades and the yen and dollar continue to be the main safe haven plays.

Our Latest Asset Allocation Views
Equities: The upcoming EU meetings are unlikely to provide enough clarity and detail to settle the debate about what lies immediately ahead for equity markets, except more volatility, while the medium term outlook remains fraught with uncertainty. Even so, a neutral equity position is retained given relatively low valuations and the belief that the EU authorities will eventually be forced to avert a disorderly financial crisis. An outlook of low economic growth, low inflation and low interest rates in a deleveraging world suggests a relatively defensive approach to geographic, sector and stock selection. This implies tilts towards the U.S., Asia Pacific and emerging economies to capture growth, defensive sectors and strong companies with healthy balance sheets. Good quality, high yield stocks should also be favoured in a low yield environment.

Bonds: With main market government bond yields at such low levels, it makes little sense to increase weightings unless a U.S. recession and/or a eurozone financial collapse is expected. In recent weeks U.S. and U.K. yields have fallen to generational lows, and on fundamentals the massive bond rally appears overdone, especially with the scale of government debt and deficits. The dangers of a turn in sentiment, however, were made abundantly clear with the recent rise in German yields, previously the main safe haven, as well as those in France. Given current growth uncertainties, still sizeable attempts at monetary stimulus via bond purchases and no respite yet from the eurozone debt crisis, however, yields could stay at lower levels for quite a while longer. Investment grade corporates offer better value but upside is limited, while emerging market debt should be reconsidered following recent falls and currency weakness.

Property: After such a strong yield impact-led recovery in capital values the pace of advance in the U.K. property market has slowed to a crawl. The weight of money chasing high quality properties generated a near boom and prime yields seem very fully priced. With banks becoming ever keener to reduce risk assets they will increasingly supply the market with portfolios of properties from involuntarily built stockpiles. With secondary property yields set to move out and lower levels of investor interest in prime properties at current yield levels, this will inhibit further gains in capital values and, indeed, they could well decline next year. Selectivity is important and Central London remains favoured. With yields in excess of 4% above ten-year gilts for even some prime properties, the sector should still outperform cash and government bonds from current levels.

Commodities: Predicting commodity returns is difficult enough given the very broad spread, high volatility and problems associated with rolling over futures contracts on returns. It has become even harder as a result of the uncertainty created by EU sovereign debt issues, a weak U.S. recovery and signs of a Chinese economic slowdown. Commodities such as crude oil and industrial metals have rallied smartly from recent lows and as long as the Chinese economy avoids a hard landing and the U.S. economy experiences nothing worse than a modest recovery, the pace of world economic growth should be sufficient to ensure that the prices of supply constrained industrial materials, such as oil and copper, will hold up next year. Gold reached a new closing peak of $1,898/oz before its recent reversal but remains favoured by many investors worried that a far worse fate awaits the global economy. Scarce supply and strong demand will keep prices elevated until sentiment turns and real interest rates rise.

Currencies: Currencies remain as volatile and as difficult to predict as ever and near term trends will depend on the authorities' response to current financial turmoil. The yen is unlikely to strengthen too much further against the dollar, given counteracting flows from the central bank while the Swiss franc remains pegged to the euro. In recent months the euro has lost all its interest rate differential support and, with the eurozone crisis an ongoing issue, sterling and particularly the dollar should continue to outperform despite further QE. After its recent substantial decline, however, the euro is likely to be driven by market sentiment towards resolution of the eurozone financial crisis i.e. it will remain volatile. Asian/emerging market currencies are still undervalued despite short term capital flight and greater uncertainty.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.