With corporate earnings growth having slowed since last year, consensus is baking in a rebound. However, with economic growth stagnant and wage pressures building, there is a risk that corporate margins will come in weaker than expected, according to Karen Ward, chief market strategist for Europe, the Middle East & Africa at JP Morgan Asset Management.
“The equity markets have been willing to ignore the deterioration in the economic data hoping that a downturn will be avoided, helped by central bank stimulus,” she said.
“If the data remains weak, delivery of the hoped-for stimulus seems highly likely. Whether the stimulus will be enough to extend the economic expansion, only time will tell.”
Investors have historically tended to benefit from de-risking towards the end of the cycle, but Ward said that with central banks having failed to normalise rates this time around, it is doubtful whether domestic bonds and cash can play their usual defensive role.
Here Ward and Mike Bell, global market strategist at JP Morgan, suggest five steps to prepare your portfolio for the final stage of the cycle.
Go neutral risk, not underweight
Bell said it doesn’t make sense to be too bearish via a significant underweight or short position in equities, as while earnings growth is slowing and there is the potential for trade wars to escalate, this has been true for much of the past six months, when markets have surged ahead.
However, within equities he is reducing risk by favouring large caps over their smaller counterparts, which is something he said is particularly important in the UK.
“The story that a lot of fund managers are talking about is one where there’s a discount in domestic stocks because of concerns around Brexit and that therefore presents an opportunity,” he explained.
“The problem is that by playing the domestic story in the UK, a lot of fund managers have ended up significantly overweight mid and small cap stocks.”
Bell pointed out the average active manager in the IA UK All Companies sector currently has a 45 per cent weighting to mid and small cap stocks, compared with 20 per cent from the FTSE All Share.
While this has been a profitable position to take during the bull market, he said problems will arise if the data continues to deteriorate.
“If the trade war escalates and we go into a more difficult period for the economy, there is a pretty consistent pattern of small cap stocks underperforming.”
Buy quality
Ward said screening for quality is particularly important to be sure a portfolio doesn’t contain the companies that have overleveraged in this expansion.
Bell added that, unsurprisingly, quality stocks tend to outperform in a downturn. However, he said that what may come as a surprise to investors is what happens to the relationship between growth and value.
“What’s interesting is that relative to value, growth has been underperforming when equities sell off,” the strategist continued.
“So growth underperformed in Q4 of last year and then as equities have recovered in the first half of this year, growth has outperformed again relative to value.
“A lot of investors I speak to have in their mind that growth is something you want to own when the economy is doing badly and that value requires a positive cyclical backdrop.”
However, Bell said the opposite is the case – as long as it is outside of a financial crisis. The reason for this is that value indices have a large weighting to financial stocks, so during a recession that is also a financial crisis, value tends to underperform – as was the case in 2007 to 2009.
“But the banks have almost doubled the capital they had in 2007,” he added. “And I think the next economic downturn when it eventually arrives will be a normal recession rather than a financial crisis.
“And hence our expectation is the more normal pattern that the more expensive growth stocks underperform the cheaper value stocks when economic growth eventually rolls over.”
US Treasuries still offer protection
Bell said that while gilts and European government bonds look unattractive, he believes US Treasury yields can still fall further in an environment where risk sentiment deteriorates.
“If the Fed were to cut in an economic downturn, they’d probably be taking interest rates close to zero, in which case you’d expect a further rally in 10-year Treasuries.”
He sounded a not of caution, however, saying the trade is riskier than it was when yields were at 3.2 per cent and they could be at risk of rising were there to be a rebound in global growth.
The strategist pointed out you also have to consider hedging costs, but said it is worth paying up to 2 per cent to hedge a Treasury into sterling.
“You give up the yield, but if you buy a Treasury with a 2 per cent yield as a hedge to your equity book, you’re not buying it because it has a 2 per cent yield, you’re buying it as a piece of insurance,” he added.
“But in a scenario where economic growth deteriorates further, it could trade with a yield of something like 1 per cent.”
Ward said other options include traditional safe-haven currencies such as the Japanese yen, as well as gold.
You can’t rely on hedge funds
Bell said that a lot of hedge fund-style strategies that take long/short positions in equities have a higher beta to equity markets than is ideal.
“Even equity-market neutral funds, which are meant to have very little exposure, historically have quite a high correlation when the market turns.”
Instead, he prefers macro hedge funds, which base their holdings on macroeconomic views of individual countries.
“Within alternatives, flexible strategies such as global macro funds have historically protected portfolios during market declines,” said Ward. “Macro funds can be nimble and can shift assets globally and by asset class, and use derivatives to insulate portfolios in periods of higher volatility.”
Infrastructure for stability
Ward said that core global infrastructure may also help to diversify portfolios and that in return for a lack of liquidity, real assets can offer a relatively defensive income stream.
Bell pointed to a chart (above) showing there were some capital losses on infrastructure during the last recession, which was to be expected.
“But on the lower risk assets, so not your toll roads, for example, but your contracted revenue streams, your regulated utility plays, the reliable nature of the income stream stands a good chance of buffering the portfolio and offsetting some of the capital loss.
“If you are able to deal with the lack of liquidity, then we think that things like infrastructure look more attractive than private equity or private credit, given the defensive income stream.”