Despite recent pessimism about the economic cycle and investment environment companies’ fundamentals continue to look strong, according to HSBC Global Asset Management’s Joseph Little.
After the stellar investment returns of 2017 and a disappointing 2018, the HSBC global chief strategist, noted that in 2019 markets will likely “go back to reality”, where valuations remain sound and present opportunities to back growth at reasonable prices.
“After the phase of synchronised global growth from late 2016 to early 2018, the global economy has lost some vigour,” said Little.
“According to our global Nowcast - a real-time measure of economic activity - after being well-above trend at the start of 2018, global growth is now back to its average rate of the last five years.
“This is hardly a disaster, and we think the probability of recession still looks low, but it does mean that, as we approach 2019, the economic system is moving ‘back to reality’.”
As the below chart shows, global markets have delivered a strong performance since the onset of the global financial crisis more than 10 years ago.
In 2017, some 120 economies - accounting for three-quarters of the world’s GDP - saw a pick-up in growth in year-on-year terms according to the International Monetary Fund (IMF). This was the broadest synchronised global growth upsurge since 2010.
So far in 2018, however, the main markets have delivered losses, with the S&P 500 the only index in positive territory with a 1.99 per cent gain, in local currency terms.
Performance of indices over 10yrs
Source: FE Analytics
However, Little said corporate fundamentals continue to look good, but the investment themes are changing as 2019 approaches.
The global economy, the strategist noted, is going from cyclical divergence in 2018 to running on two main engines of growth: China and the US.
As such, the outlook for these two engines will be of key importance for determining the path of the economy in 2019, Little highlighted.
“The uncertainty around the Chinese macro outlook is high at present,” he explained. “Looser financial and monetary conditions should result in solid growth but, given the high debt levels in the corporate sector, there are concerns that monetary policy may not be as effective as in the past.
“The levels of debt are also a constraint on the amount of loosening the authorities will be willing to use to engineer an upturn.
“Having worked hard to slow the pace of debt accumulation and rein in financial risks, they will not want to move backwards by reflating the debt bubble. They are still aiming to strike a balance between maintaining growth and limiting financial threats.”
In Little’s view, the US economy is set to slow from a strong starting point of well-above-trend growth to a more average pace by the second half of 2019, accompanied by a gradual rise in core inflation.
US CPI over 5yrs
Source: St Louis Fed
If this outlook materialises, the HSBC strategist noted the Federal Reserve is likely to follow through on its current projections of around 100 basis points of hikes between now and end-2019.
This, he said, could best be described as a “policy return to neutral” rather than outright restrictive.
“Crucially, market pricing is closer to the Fed’s scenario than it was at the start of 2018,” he noted.
However, where valuations remain sound, the current backdrop presents an opportunity to back growth at a reasonable price.
“We prefer global equities rather than global credit, although we think that credit has become a bit more attractive,” said Little.
“For us, current valuations imply that we should now focus our tactical risk budget on Asian and emerging market equities. In multi-asset portfolios, we also think there is value in some US Treasuries, especially compared to European government bonds.”
Looking back on 2018, the strategist noted conventional notions of safety haven’t worked over the past year, with only the US dollar and US equities having recorded gains of the main asset classes and even traditional diversifiers having performed poorly.
“The typical sources of portfolio protection were ineffective. From an asset allocation perspective, our portfolios should reflect this shift in the market odds,” said Little.
Performance of indices YTD
Source: FE Analytics
“We have seen a significant re-pricing of US fixed income assets this year. Our measure of the US ‘bond risk premium’ – the future reward for owning bonds over cash – has increased during the year and is now slightly positive, while we think short-duration US bonds now offer attractive risk-adjusted prospective returns.”
Outside of the US, Little noted the risk premium on global government bonds remains very negative.
“On balance, we are still inclined to be underweight duration on a global basis, but relative to our position last year, our overall portfolio duration should increase,” he said.
“In global rates, we have a preference for US Treasuries, and we favour the short-end and the belly of the curve.
“Perhaps our clearest current preference is for a relative-value trade between more attractive US Treasuries and very expensive German bunds.”
Little also added that risks remain, for example, if inflation trends build or if the market starts expecting stronger inflation.
Given that macroeconomic and political issues will likely have a significant impact on market action going forward, he said investors need to build portfolio resilience in such a “tricky” environment.
“Looking at short-duration parts of US rates and US credit in particular, we find that many traditionally perceived safe haven asset classes are now offering much better carry than in previous years,” said Little.
“This shift in pricing allows us to build portfolio resilience by adding some shock absorbing and diversifying fixed income asset classes to our multi-asset portfolios: we think this is a good hedge in case the macro landscape evolves less favourably than we expect.”