Investment Strategy: Investment Strategy - Trade dispute challenges outlook

News item -

Our view regarding the global economic outlook was challenged when the trade dispute between the US and China took a step backward. Its re-escalation was a major setback for the global economy and what had been our cautiously optimistic view of growth. While we continue to believe that recession will be averted in the US, ABN AMRO has downgraded its already muted economic growth forecasts for the eurozone, the US, emerging Asia and China.

All of the key central banks have responded to the rising economic risks related to the slowdown in growth and the re-escalation of the trade conflict. The Fed has walked back projected rate hikes in 2019 and is now hinting at possible rate cuts. ABN AMRO expects that the Fed will cut rates three times between now and the first quarter of next year. The European Central Bank is also indicating its willingness to provide more stimulus, which we think they will restart later this year. And, in China, both the government and the central bank have acknowledged that there are still plenty of policy instruments and room to support economic activity.

Modest global growth expected

The global economy is growing, but at a very modest rate. The slowdown that developed in 2018 and into 2019 was caused by a range of headwinds, including Fed tightening, the trade conflict, China’s economic policies and some problems in important sectors, such as the European car industry. These headwinds appeared to be abating earlier in the year and a number of cyclical indicators started stabilising or improving. The re-escalation of the trade conflict between the US and China dealt a major blow to this more positive trend. The US president’s unexpected antagonism toward Mexico was also a surprise, which could lead other trade negotiators to view him as an unreliable, or at least inexplicable, negotiator.

Neutral stance toward equities continues

In this environment, the ABN AMRO Investment Committee made no adjustments to its overall asset allocation. It continues to favour a neutral stance toward equities, while bonds remain out of favour (underweight). Within commodities (overweight), gold is preferred. Within the fixed income portfolio, the weaker economic picture and the belief that lower interest rates would be around for longer than had been expected, led to a preference for longer duration in bond portfolios, i.e. making them more sensitive to falling rates. (Bond prices rise when rates fall.)

Low visibility in stock markets

Stock markets in the US and Europe continue to range-trade, a situation which began in the US in 2018 and in Europe in 2015. Markets are also experiencing short-term volatility, due to tweets from the US president and other noise. The outlook for earnings is weak. Earnings expectations for European stocks is 4.3%, with 3.3% earnings growth expected in the US. Given the lower growth environment, even these modest earnings expectations could now be overly optimistic. However, central banks indicating their willingness to provide support when needed, is providing an important ‘put option’ for equity markets.

Even though no recession is expected in the US or for the eurozone as a whole, economic momentum is weakening and there is little visibility regarding upcoming improvement. In this environment, a neutral stance toward stocks is advised. Within sectors, we continue to favour the information technology (IT) and communication services sectors, due to their stronger earnings growth. In terms of regions, the US is favoured over emerging markets and Europe. Despite higher valuations compared with other markets, the US remains the leading market, based on a stronger economy, higher earnings growth and the dominance of the US IT sector.

Bond markets react to economic outlook

The bond market appears to be expressing a bleak view of the macroeconomic outlook. This perspective is evident given the combination of very low, long-term core bond yields; an inverted US yield curve between three months and ten years (which can be a precursor to a recession); and short-term futures contracts that are now pricing-in a rate cut of 25 basis points by the US Federal Reserve in July, with several more rate cuts expected to follow.

We believe that the pressure on long-term core bond yields will continue. And this will be due to either the Fed cutting rates (which we expect) or the Fed not cutting rates and the macroeconomic picture deteriorating. We therefore suggest that bond investors adopt a longer duration position relative to their benchmark.

Lengthening the duration of a bond portfolio is the same as increasing the portfolio’s interest rate sensitivity. It is a favoured tactic when interest rates are expected to be lower for longer, which is our expectation.

For the rest of a bond portfolio, the current environment continues to be conducive for credit spreads, especially if central banks step-in with further support. We therefore prefer higher yielding bonds, investment-grade corporates and emerging-markets debt.

Alternative strategies: gold and hedge funds preferred

Gold prices expected to rise

Within alternative investments, we continue to favour gold, as a segment of the overall commodities sector, and hedge funds. We remain positive on gold not only from a technical point of view, which supports the case for gold prices to rally towards the end of the year, but also owing to the expected actions of central banks. An environment of easier monetary policies is typically supportive for gold prices. This is because as the interest rate difference between currencies and gold declines, gold, as a non-interest paying asset, becomes more attractive. ABN AMRO’s precious metals expert forecasts that by year-end gold prices will rise to USD 1,400 per ounce.

Hedge funds for diversification

Hedge fund investments continue to be of interest, given the diversification benefits that a combination of hedge fund strategies can contribute to a portfolio. Hedge fund strategies also offer the potential to maintain performance even when other asset classes face difficulties.

Conclusion

After a positive start to the year, the macroeconomic outlook worsened over the second quarter, exacerbated by the re-escalation of the continuing trade dispute between the US and China. The ABN AMRO Investment Committee had scaled back its allocation to stocks in January, moving from a moderately overweight stance to its current neutral position. Risks were further reduced by selling the broad commodity exposure in mid-April. A further adjustment occurred in May, when after markets rose by around 16%, the decision was made to rebalance the equity allocation back to the stated tactical asset allocation for client portfolios. Given the number of factors currently at work, including the possibility of either a trade truce or further escalation occurring around the G-20 meeting later this month, rising political risks and US accusations against Iran regarding the oil tanker attacks near the Persian Gulf, we continue to take a cautious approach to markets.

Richard de Groot, Chair, Global Investment Committee
richard.de.groot@nl.abnamro.com

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