Yet even if market turmoil has made rather too much of the economic risks we face, it has served to highlight that nominal growth is simply too low and valuations are too high to expect significant upside in most asset classes.
Against this backdrop, we maintain our view that the economy will continue to grow slowly but positively and that the risk of outright recession remains low. Recent worries about a US manufacturing recession look overblown: these woes strike us as more of a consequence of the oil-price plunge and the emerging markets reversal than an independent source of drag on the global economy.
Our conviction in continued uninspiring growth notwithstanding, we are becoming more cautious on asset outcomes as we cannot ignore impaired sentiment, tighter financial conditions and increased tail risks.
Prior monetary policy action from the world’s central banks borrowed returns from the future and now that future is here. We dispute the idea that policymakers have run out of ammunition, but acknowledge that loose monetary policy is – at best – a stabilizer, not an accelerant. It will now fall to other factors – notably fiscal policy, consumption and corporate investment – to generate an incremental growth impulse.
Now is not the time for heroic directional bets. The prevailing environment of muted asset returns instead demands a tone of caution in the overall asset allocation mix which leads us to a preference for lower beta markets and relative value positions.
We have adopted a broadly neutral stance on stocks versus bonds, preferring to hold “equity-like” beta through High Yield credit and have maintained our developed market over emerging market preference – in particular the U.S. and Europe. We also see duration as an important component of portfolios despite low yields.
Although stocks still look preferable to bonds on a historical basis, simple valuation metrics miss some of the subtleties behind investor preference in the current market environment. Nominal growth is simply not high enough to drive significant earnings upside in the near term and the valuation of stocks is too high to look through the lack of earnings growth.
We expect stocks to remain stuck in a broad trading range, likely restricted to the upside by last year’s highs and to the downside by this year’s lows. So while we anticipate developed market equities will ultimately deliver positive returns in 2016, we expect the magnitude to be disappointing: low to mid-single digit. This calculus is at the heart of our decision to reduce our stock-bond view to neutral, in favour of taking “equity-like” risk through credit.
With spreads still elevated a diversified portfolio of extended credit is an attractive substitute for stocks, and we see the most upside in US and European high yield credit. We favour high yield in part because of prevailing macro conditions – stable enough to avoid damage to balance sheets, a tailwind for credit, but insufficiently strong to significantly boost corporate income statements, a headwind for stocks, and also because U.S. high yield credit has overpriced recession risk and as a result is dislocated from equity.
Government bond prices also appear to, superficially, overstate recession risks; but government bond markets are increasingly dominated by price-insensitive buyers, whose ranks include liability hedgers, regulated buyers, and central banks. In addition, increased macro uncertainty makes investors ever more willing to look through low or even negative yields and maintain a bid for duration.
As at the start of the year, the trajectory of the U.S. dollar remains a key consideration to our asset allocation outcome. There is some scope for a little residual strength but we see the dollar gradually starting to consolidate, as the market prices in the Federal Reserve’s glacial path of hikes.
If more-stable and uniform global growth aids dollar consolidation, that would signal increased risk appetite and a better outlook for emerging markets. But if the dollar falters because of sputtering U.S. growth, the outlook would darken for risk assets generally.
