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Citiscape view

No lack of opportunities despite low returns

Despite a challenging time for markets over the last year, the next recession looks at least a year away and investment opportunities can still be found. 

Increased expectations that major central banks will keep rates low for longer than was expected are lengthening the economic cycle even further.

The world economy remains on shaky ground. Expectations of when the next recession will occur will be key to market sentiment and investment decisions this year.

After the slowdown experienced late last year, the most recent manufacturing indicators suggest that the recovery is still fragile and the ongoing trade tensions are not helping the overall confidence level.

China’s latest stimulus is not yet visible in the data and European economic figures, especially for sectors exposed to global trade, are not encouraging. However, other areas of the economy, such as consumption and construction, are holding up and suggest a temporary manufacturing slowdown.

The uncertainty surrounding the economy would probably be worse were it not for the US Federal Reserve (Fed) signalling a slower pace of rate hikes than was expected earlier in the year.  Indeed, the market is currently pricing for a US rate cut at some point this year.

We think rates will be held for the foreseeable future. In any case, increased expectations that major central banks will keep rates low for longer than was expected are lengthening the economic cycle even further. That said, economic growth is unlikely to be spectacular in the next couple of years.

A more tactical and differentiated market

While central banks are sustaining the economic cycle, it is undeniable that the cycle has been long. March’s inversion of the yield curve, when 3-month US bond yields exceeded 10-year bond yields, is one of the signs that it is late in the cycle and the risk of recession is rising.

We would not assign as much weight to the inversion on this occasion. The yield demanded by bond investors to tie up money in long-maturity bonds is extremely low. Quantitative easing has also artificially compressed the spread between the short-end and the long-end of the yield curve.

Investing in a late-cycle environment is our first thematic. There is likely to be more dispersion between the performance of individual stocks and sectors. We think that simply buying exposure to an equity index is not likely to deliver much return.

Instead, we think that a market-neutral, active strategy still offers potential upside as differentiation between companies is likely to increase. With heightened volatility likely, companies exposed to structural growth seem well placed. The capacity for companies with strong balance sheets to deliver consistently good growth is another factor worth looking for.

Carry and yield

Another theme to bear in mind for the next few months is carry and yields. We think that price returns are going to be modest across asset classes. With lacklustre growth and valuations which already fully price the expected growth, most asset classes are unlikely to see strong returns.

Yields and carry are needed if investors want to achieve higher total returns in their portfolio. In equities, we think that companies capable of growing dividends are the best way to get exposed to that theme. In fixed income, emerging markets hard currency bonds are worth considering, especially now that the Fed has turned more cautious.

Tactical opportunities

The Fed’s pivot is happening at a time when the US labour market looks very tight, with unemployment close to lows last seen in the 1970s. Wage growth has remained subdued but has started to move higher in the recent months. While it is still at relatively low levels, we cannot rule out an inflation surprise in the second half of the year. We are not expecting high single-digit inflation growth. But even if inflation moves up by one or two percentage points, this would have investment implications.

This is the basis for our third investment theme. The most important takeaway on this theme is to stay invested rather than holding too much cash. Exiting markets too early, especially if inflation starts to rise, is painful. Inflation-linked bonds are a possibility.

Equities with pricing power or low product demand that is little affected by price changes could also be considered. Finally, if real rates start to fall, this should support gold prices. The latter also provides a hedge should markets start pricing in a recession at some point, something that happened last December.

Episodes when market expectations change on when the next recession is likely may provide good investment opportunities. This is our last investment theme. Markets will be more focused on recession risks. This creates tactical opportunities which could be short-term but may offer the chance to enhance performance.

Emerging market prospects looking better

From an asset class perspective, we find that emerging markets (EM) assets continue to be the more attractive on a broad basis. Differentiation between emerging markets will be key.  Keeping that limitation in mind, we think that EM assets, both equities and fixed income, are generally more attractive than developed world assets.

In equities, we think that the US and EM together offer the best combination. Japan, Europe and the UK are facing different headwinds which make them less attractive at the aggregate level. Nonetheless, opportunities persist in those markets from a bottom-up perspective.

In fixed income, high yield markets are looking fully priced and investments should be considered selectively. While investment grade debt has seen a large increase in BBB-rated bonds in the last few years, triggering a deterioration of the average rating, the outlook appears supportive. Although the volatility in EM fixed income is going to be challenging at times, the yield spreads should provide some cushion for what should be short-lived events.

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Market Perspectives April 2019

Find out our latest key investment themes. And with volatility set to stay elevated in 2019, can markets head higher still this year?

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