In our last quarterly outlook, we said:
It now seems that the key to Capital market performance going forward is contingent on the US Federal Reserve cutting rates in July and potentially September. This is possible assuming global economic growth does not suddenly improve dramatically. This may seem counter intuitive, but unfortunately we are in an environment where good economic news is bad news for the equity markets.
If in fact the US Federal Reserve does provide another dose of monetary stimulus, it will push the start of the next recession further out into the future. Why is this important? Equity bear markets rarely occur unless corporate earnings contract on a year-over-year basis, and earning contractions only tend to occur during recessions. In the absence of a recession, we shouldn’t expect earnings to contract, allowing the expansionary market in equities and credit to continue for a while longer.
A significant part of Portfolio management is about managing risk. As mentioned earlier, in the absence of a strong conviction, it’s preferable to be somewhat neutral in out allocation to risk assets, even if we view the bull market in equities to continue for a while longer. The main culprit for our more cautious stance is due to exogenous events outside of the economic environment that could tip the global economy into a recession. Those exogenous events are geopolitical in nature, namely:
In the absence of any of these manifesting themselves, we should expect the equity and credit markets to grind higher, but in a zig zag fashion – similar to what we’ve experienced over the past year. But at the same time, we must be mindful of all geopolitical risks.
While we don’t believe any substantial agreement will be reached between the U.S. and China in the short term, we are hopeful that tensions will ease. That said, a ratcheting up of U.S.-China trade tensions is one of the principal risks going forward, as it will continue to dampen economic growth expectations.
Assuming tensions do simmer down, there are some positives we can hold onto; surveys show that professional investors are overweight cash and government bonds and underweight equities, and within equities, overweight the defensive sectors of the market. Overall, investors are still very defensively positioned which could be a catalyst for the equity markets should geopolitical issues fade, and economic conditions solidify.
If the “rosier” scenario does play out, we would look to take on more risk in the portfolios through an increase in equity and credit exposure. Within equities, we think that a recovery in Chinese growth will spur a recovery in growth in the rest of the world. While many believe that a trade war would be devastating to the Chinese economy, one must understand that exports to the U.S. account for only 4% of Chinese GDP. The prime catalyst for a deceleration in Chinese growth last year was due to regulatory efforts to slow down shadow lending within the economy. Those efforts ended at the end of the year, as we’ve seen a pickup in lending since then. If, as we expect, that Chinese growth is bottoming and turning up, then Europe, Japan and select emerging markets should experience a pickup in their economies as well, which should be positive for their respective stock markets.
In the absence of evidence that Chinese growth is accelerating, we still have a bias to US equities, but will look to increase exposure to non-U.S. equities as evidence becomes more conclusive.
As mentioned earlier, we will be adding exposure to non-traditional fixed income asset classes given their longer-term superior risk-adjusted return characteristics and ability to provide some diversification benefits to traditional stock, bond and preferred share portfolios.