The investment landscape is unusual at the moment. The central banks are adopting unprecedented policies which are driving bond yields down to historic low levels. The global trade war is escalating and beginning to impact corporate supply chains, and geopolitical and policymaking risks are high – yet both equities and bonds have made strong gains so far this year. Looking forward, there are still many investment opportunities available on a selective basis.
Two factors are particularly important in examining the investment landscape.
First, the global GDP growth rate is peaking. However, Citi Research still expects a decent 2.7%, with particular strength in emerging countries, and no immediate recession is anticipated.
Second, the US-China trade war is not likely to end soon and can only partly be o?set by central bank easing measures.
In this climate, asset managers should be cautious with return expectations and should expect rising volatility.
Fixed-income markets look expensive and could get more expensive with further price rises in the short term. Equities, meanwhile, o?er further long-term opportunities, but could face short-term pressures.
The US dollar is expected to weaken as focus increasingly turns to funding the US budget de?cit.
Opportunities in bond markets as central bank easing continues
As the trade war intensi?es, central banks have pivoted to a more dovish stance. The US Federal Reserve has cut interest rates three times this year. Meanwhile, in September, the European Central Bank lowered the deposit rate by 10 basis points to -0.5%, as well as restarting its bond buying programme. In anticipation of this central bank monetary policy easing, bond markets have had a spectacular rally so far this year, with the global aggregate index rising 6.4%.
As central banks buy into ever-smaller bond universes, yields are likely to fall to historically low levels. Already US$13 trillion of global bonds currently o?er negative yields, guaranteeing that buyers will lose capital if they hold to maturity.
Despite this unusual environment for ?xed income, there are three areas that look attractive:
- US investment grade bonds, where yields and spreads are, on average, 250 basis points higher than those available in European investment-grade bonds.
- Emerging-market US dollar bonds, where credit metrics are generally improving and political risks are falling.
- European high-yield bonds, where the outlook for defaults is low and leverage is only modest.
How the trade war is affecting global equities
The trade war is having two main impacts on global equities. Firstly, corporate earnings have come under pressure. Average earnings-per-share growth has halved. There are increasing signs that companies faced with higher tari?s are mostly taking the hit on margins rather than raising prices. Second, policymaking uncertainty is impacting sentiment for corporate treasurers considering expansion plans and for investors looking to value stocks. Both are increasingly challenged in making long-term commitments with con?dence. Any signs of de-escalation would result in a rebound in global manufacturing as inventories are rebuilt.
How the trade war is affecting Europe
From a European perspective, there are three factors to monitor with regard to the trade war.
First, European manufacturing exports to both the US and China are weakening. In Germany, for example, exports to China correlate very closely with German industrial production. Looking forward, it’s possible that, as capital expenditures fall, there could be implications for European employment and wages, which in turn will hamper domestic demand.
Secondly, supply chains are being impacted and corporate uncertainty is rising as visibility lessens.
Thirdly, later this year the US is likely to turn its attention to the EU, with speci?c demands to import more US agricultural products and lique?ed natural gas (LNG).
Where the equity opportunities are
With that increasingly challenging backdrop for equities, investors need to select carefully. There are opportunities in several areas. Within the developed markets, the focus should be on defensive value stocks.
Cyclical stocks typically peak a few months ahead of growth peaking and this cycle is expected to be similar. Undervalued stocks tend to have less probability of downside earnings surprises, so they often do well as the cycle starts to turn down.
“With that increasingly challenging backdrop for equities, investors need to select carefully”
As an example, many European car stocks look undervalued, with price-to-earning valuations below their dividend yields. The worst-case ?ndings of the US 232 investigation into the automobile sector to determine the e?ects of imports on national security are already priced into stocks.
Another area that should perform well is high-yielding stocks, especially those whose dividend payout ratios look sustainable. Sectors like healthcare should show positive earnings growth even as the economic cycle turns down, supported by ageing populations and rapid developments in digital technology. A theme that o?ers potential for further stock price gains is ‘de-equitisation’.
This includes companies with limited organic growth opportunities that are able to use their strong balance sheets and cash-?ows to buy back their own equity and, in so doing, raise their earnings per share and returns on equity. The European equity markets o?er selective deep value opportunities. For example, in the banking sector, our preferred half dozen bank stocks (mainly in the Benelux and Scandinavian countries) o?er these average characteristics: price-to-book valuations of 0.7X, returns on equity of 8% and rising, core tier 1 ratios of 13%, and dividend yields of 6%. Even with sluggish average loan growth of 3.7%, earnings have the potential to progress with cuts in cost to income ratios, currently averaging a high 80%.
Stock market volatility does not necessarily mean that recession and a bear market are imminent. Instead, investors should embrace volatility with capital-market trading strategies. For example, equity investors can take advantage of elevated volatility through option strategies that limit potential for capital loss while o?ering coupons that give above-average yields.
Gaining exposure to emerging markets
Emerging markets continue to o?er long-term opportunities. Within emerging markets, Citi Private Bank’s preferred areas are Asian equities and Latin American ?xed income. Asian equities o?er more growth with China as the locomotive, while corporate governance and transparency are reducing the risk premium. In addition, the owners and traders of Asian stocks are now more institutional than retail, which is reducing irrational share price moves and stock market volatility.
“Asian equities o?er more growth with China as the locomotive, while corporate governance and transparency are reducing the risk premium”
Latin American policymaking is more orthodox, which in turn is driving improvements in metrics like debt/GDP, budget de?cits/GDP, foreign exchange reserves/ exports, and o?shore debt/total debt. In both continents, there is a structural pickup in domestic demand as GDP per capita levels rise to levels where spending on consumer items tends to pick up strongly.
For this reason, Asia and Latin America are less dependent on exports than they have been in previous cycles, and that should help insulate them somewhat from the global trade war.
Look for entry levels in sterling and UK equities
With regard to the UK, our advice to clients at the start of the year has been not to chase rallies in sterling and equities, despite their cheap valuations (sterling in real exchange-rate terms, equities with a multiple of only 11.5X and an average dividend yield of 5.1%).
Looking forward, both are closer to entry levels. A Conservative majority in the general election, as forecast in most polls, would be positive for both Sterling and UK equities. When accumulating Sterling and UK equities, the approach should be gradual as the country moves towards the end of the first stage of Brexit in January 2020. Gilts look expensive, ahead of probable ?scal expansion whoever wins the election and whatever the Brexit outcome.
Too soon to get overly bearish
While the easy gains for this cycle are behind us, a selective approach can still generate decent returns, so the appropriate approach is to safeguard assets as the trade war continues and invest in assets that will bene?t from ongoing central bank liquidity and are fundamentally sound.
Je?rey Sacks is Head, EMEA Investment Strategy at Citi Private Bank and an alumnus of London Business School’s MBA programme
This article was originally published in LBS Review
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