05 Jul 2019
Every risk has attached to it a price. Lately the facts have evolved, mostly in a negative direction: trade wars have resurfaced, risks of an unfavourable Brexit are back in focus, and at least some corners of financial markets are firing warning signs about the future path of economic and earnings growth. Global central banks have turned more dovish, each citing this medley of challenges. Yet asset prices have soared, with some markets a whisker away from their highs. “When the facts change, I change my mind. What do you do?”1
In multi-asset portfolios we have been turning progressively less constructive on equity risk since the end of February, and more optimistic on corporate credit (Figure 1). This sentiment appears to be shared by the analyst community, where aggregated bottom- up earnings expectations for global equities, for example, have stepped 9% lower from a year ago for both 2019 and 2020 (Figure 2). Today, earnings growth for global equities for 2019 is expected to be zero, from 10% in the final quarter of last year (Figure 3).
Global sovereign markets also bear a warning flag: with over half the US yield curve inverted and nearly 70% at 10 basis points or flatter2, the experience of the past 40 years points to mounting risks of recession. Yield curves are an imperfect indicator of real activity3, and although economic indicators are soggier than they have been there are sparse signs of recession – we do not anticipate economic contraction this year or next. Yet inverted yield curves cannot be ignored: for instance, inversion is a key driver of the closely watched New York Fed Probit model that now points to a one in three chance of recession in the next 12 months. The Fed and financial markets pay attention to this.
Cue in global central banks, where the latest “pivot” towards additional easing has been predicated on some combination of frameworks (such as the NY Fed’s) and mounting external risks from trade disruption. Today, markets price in more than 100 basis points of rate cuts for the US by the end of 2020, with rising odds of more negative interest rates in Europe, perhaps as soon as this year. As we discussed in last month’s update (Asset Allocation Update, May 2019), insofar as the move lower in discount rates remains sufficient to offset a weak earnings or cash flow picture, risk assets such as equities may be supported. But it is a fragile balance better suited to corporate bonds.
Source: Columbia Threadneedle Investments, 21 June 2019.
To be sure, central banks will most likely deliver easier policy. A failure to do so at this point would probably result in an undesirable tightening in financial conditions. It may be that this boosts growth and corporate earnings expectations. It might also turn out that risks around trade wars and Brexit dissipate. Or, risk premia could creep back into averagely priced marked markets, restoring a valuation cushion to protect against these risks.
Source: Columbia Threadneedle Investments, 21 June 2019. The 2019 expectations are highlighted in yellow box.
At present, our forecasts point to fewer rate cuts than are currently priced in, in both the US and Europe, and we continue to expect higher interest rates from the Bank of England, although conviction around this has waned with recent developments.
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We expect the threat of trade wars to persist until at least November 2019, when a decision on automobile tariffs is due, with Brexit rumbling on into 2020. The Tories can change leader but not parliamentary math that remains deeply divided on all possibilities.
All in, with the facts as they are, and absent a valuation signal, taking equities down to neutral, alongside a lower overall risk appetite, feels appropriate. Easy central banks and middling, non- recessionary growth should continue to provide support for corporate bonds.
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