Painting a mixed picture

THE BUSINESS TIMES' WEALTH ROUNDTABLE

Genevieve Cua, BT Wealth Editor, poses questions to asset managers for their insights on the outlook this year

Deepak Khanna Head of Wealth Development, HSBC Bank (Singapore) Ltd. He is responsible for the HSBC Bank's wealth business, including the overall product and services roadmap. He enjoys playing squash, riding, and is passionate about painting.

Mike Brooks is Head of Diversified Multi-Asset, Aberdeen Standard Investments. He manages a suite of highly diversified multi-asset portfolios investing in a broad range of asset classes. He enjoys spending time with his family and playing golf.

Eoin Murray is Head of Investment, Hermes Investment Management. He is a member of Hermes' Executive Committee and also responsible for the investment teams' consistent delivery of responsible, risk-adjusted performance. He is a member of the search and rescue team for a national park in England.

Michael Fredericks is Managing Director and Head of Income Investing, BlackRock Multi-Asset Strategies Group. He is lead portfolio manager for a suite of income-oriented investment solutions. He is an ardent sports car enthusiast.

2018 turned out to be a challenging year, as concerns over rate rises, the overhang of a US/China trade war and fears of an impending recession weighed down all assets. What is in store in 2019? Our panel of experts share their views.

What major themes do you expect to underpin markets in 2019, and how should investors be positioned on a multi-asset basis?

Deepak: 2018 was a tricky year for investors. Performance was either flat or negative across most asset classes, with only a few exceptions. Some asset classes like emerging markets performed really poorly. Returns were poor even on traditional diversifying asset classes such as US Treasury bonds and gold. There were few safe havens in 2018.

In 2019, we expect the environment to normalise as markets move back to reality. 2019 will feel a bit different from the synchronised growth that we had in 2017 and global economic growth should get back to its long-term average trend of 3.2 per cent*. Monetary policy is likely to move to neutral as the Federal Reserve policy is moving back into neutral gear. Other central banks are a bit behind but going in the same direction. Meanwhile, global inflation is creeping higher but we expect it to remain contained in 2019.

The global economy is also moving from cyclical divergence in 2018 to running on two engines of growth - China and the US. The economic performance of these two countries will be really important for determining the path of the global economy. Overall, we think the global economy is in pretty good shape and concerns about an imminent recession are misdirected, especially when we look at the continued positive trends in corporate profitability.

Mike: The synchronised global upswing of recent years is well and truly behind us as potential headwinds cloud the horizon. These include the US-China trade conflict; the fading impact of US fiscal stimulus and tightening monetary policy in the US and emerging markets; and uncertainties over Brexit and political fragmentation in Europe.

We expect populist sentiment to disrupt markets intermittently this year as people express frustration that the benefits of globalisation have not been shared equally. But we don't see signs that the global economy is at imminent risk of a recession. The sort of large economic imbalances that usually presage the end of an expansionary cycle aren't flashing red just yet. The Federal Reserve has also shown itself willing to respond to tighter financial conditions by softening its rhetoric.

Moreover, the sharp decline in oil prices should support real incomes, while China has been adding fiscal and monetary support that should begin to bear fruit. We predict a continued mid-cycle economic slowdown this year.

Still, tightening monetary policy and prospective headwinds have caused investors to question valuations. This has driven volatility and prompted declines in equity and credit markets, which have become more correlated as a result. Even now, the lower valuations are largely offset by increased risks to growth. We think volatility will remain elevated this year. Therefore, we recommend modest exposure to equities. We are similarly cautious about credit markets, where rising rates could leave weaker companies exposed and lead to a re-evaluation of spreads at this point in the cycle.

We advise investors to limit exposure to traditional assets in favour of investments that can ride out volatility. We favour listed alternatives in segments such as aircraft leasing, insurance-linked securities and litigation finance. They offer both superior growth potential and low sensitivity to the economic cycle, reducing portfolio volatility and providing protection during turbulent times.

Eoin: The three principal themes that will influence markets in 2019 are a continuation of those that drove markets in 2018, leading to significantly higher volatility: (i) slowdown in global growth, (ii) trade tensions, and (iii) populism. The US is likely to slow to the rest of the world, while trade tensions (or more accurately tech war) will continue to bubble away, even with small near-term resolutions. Meanwhile, the pain of inequality will continue to find its voice of dissatisfaction in the populist movement.

Investors should focus on quality firms with stable earnings which are best placed to weather the continued disruption. Whether debt or equity, these firms will also be best positioned to deal with unexpected events. Long-term investors will not react in a knee-jerk fashion as events unfold, but take advantage of beaten down opportunities to cautiously add to their exposures.

Michael: Before looking ahead, it's helpful to reflect on 2018 as it was one of the most challenging market environments in recent memory. In fact, it was only the second time in nearly 30 years when both global stocks and bonds ended in negative territory. In many ways, 2018 can be thought of as another reset in this economic expansion, similar to 2011-12 and 2015-16 when we last experienced such stresses. Ultimately, we believe such a reset can help extend the cycle. The causes of volatility, most notably in Q4, were around a few big themes: signs of slowing global growth, tightening monetary policy, earnings headwinds, and political uncertainty (including trade tensions). The S&P 500 had one of its worst Decembers on record.

Regarding the growth outlook, investors have, in our view, overreacted to the first signs of slowing growth and the sentiment pendulum swung dramatically from euphoria to fear. We acknowledge that we are likely transitioning to the later stages of this economic cycle and recent forward looking data has been a touch softer. For example, growth momentum has clearly slowed in some key markets like Germany and China. Yet, our base case remains that the global economic expansion is set to continue through 2019, supported largely by the US economy.

The acceleration in US economic activity we saw last year is likely to moderate as the impact from fiscal stimulus rolls off. Importantly, though, we believe that a healthy level of growth will persist through 2019, ultimately settling at levels that we have seen for most of this expansion. Our positive view is mostly predicated on the strengths of the US consumer who appears unlikely to weaken in the near term and are an important contributor to the overall economy. We would point to a strong employment backdrop, firming wage growth and high consumer confidence levels as evidence.

Furthermore, one of the major overhangs for markets in 2018 appears likely to abate this year - the Federal Reserve tightening campaign. This was one of the key catalysts for the repricing we saw across several income markets last year, but now could largely be behind us. Recent Fed rhetoric has helped ease market anxiety as it appears increasingly likely they will pause from their current pace.

We believe signs of slowing growth momentum and elevated global trade tensions provide enough evidence for the Fed to be a bit more cautious going forward. It is worth noting that markets have already adjusted downward their expectations for rate hikes this year.

Uncertainty around trade remains the biggest known macro risk and has contributed to softening global growth. However, it appears the US and China are inching towards a partial resolution that could provide some relief. Thus, should progress not be made, we could see more downside risk.

Investor anxiety remains high at the moment largely around fears of a recession and trade tensions. And while these remain legitimate concerns, we argue that risk of a recession is overblown and that asset prices today better reflect these macro risks and thus potentially less downside from here.

Please share with us one or two of your key calls or investible ideas for 2019.

Deepak: Global economic growth remains solid, and marginally above its five-year average. The economic environment continues to support strong corporate earnings and fundamentals. We still believe equities remain the best way to access global growth. Based on current valuations, we prefer Asian, eurozone and emerging market equities where prospective returns look attractive.

Geopolitical turmoil and trade issues could spark volatility and cast doubts on future economic performance, while faster-than-expected US interest rate hikes could also hit sentiment. Investors should diversity their portfolio by allocating some capital to "safe-haven" assets like high-quality government bonds. These bonds could provide a buffer for portfolios in the event of a correction. At a time of rising interest rates, shortduration bonds which are less sensitive to rate spikes are an option.

Mike: Among larger, more liquid asset classes, we favour emerging market local currency bonds on account of the relatively high nominal and real yields on offer. Currency valuations are inexpensive and underlying fundamentals sound, given the healthy medium-term growth prospects of emerging economies. It equates to an appealing risk-return profile. Certainly, the segment demonstrated resilience and lowly correlated returns last year during heightened market volatility and significant headwinds, although we remain mindful that this would not hold true in all potential scenarios.

We are also evaluating potential new investments in infrastructure. The asset class offers enduring strengths amid market volatility because it provides predictable, inflation-linked returns. The sector includes renewable energy (such as wind and solar power farms) and social infrastructure projects (such as schools and hospitals). Both make valuable contributions to society and provide long-term sustainable yields with potential for capital growth.

Separately, we have been working closely with our global Reits team to identify suitable property investments. We are exploring segments that are less closely tied to economic conditions, such as social housing funds that provide affordable accommodation to citizens with lower incomes or disabilities. These are typically supported by cash from governments and involve long-dated contracts, which again underpin revenue stability.

Eoin: We remain tactically cautious for 2019. With the US dollar likely to come under pressure as US growth dips to the levels of the rest of the world and the US Fed pausing in their rate hike cycle, it could well be that we have seen the worst for emerging markets. Equally, demand for infrastructure will continue as demand for capital will outstrip supply.

Michael: Broadly speaking, even with more attractive valuations, the range of outcomes in equities is likely much wider than fixed income and we are therefore not yet at the point of adding outright equity risk. That said, we continue to uncover attractive opportunities for income through covered calls on individual stocks. The higher volatility backdrop has led to higher call premiums and thus better income levels for covered call investors. We have generally preferred US growth-oriented sectors but have selectively added to more defensive areas in recent quarters.

We see the greatest opportunities for investors today in credit asset classes that offer significantly higher income levels than a year ago, which can be a powerful driver of total return even if price volatility remains elevated.

As an example, prices across high yield, investment grade debt, emerging markets debt, collateralised loan obligations (CLOs) and preferred stocks were all down between 6-10 per cent over 2018, making their yields substantially higher today. Notable exceptions to the repricing theme are areas like commercial mortgage backed securities and non-agency mortgage backed securities. These sectors outperformed last year, underscoring the benefits of diversification. Yet, as valuations are now relatively high, it is more difficult to add to these sectors.

On a multi-asset basis, what expectations do you have of return and the major return drivers (or deflator) that might kick in for 2019?

Deepak: Our asset allocation views are based on macroeconomic fundamentals, our proprietary economic measurements and valuation analysis.

We think the global economy is in pretty good shape and that worries about a growth slowdown or recession are over-played, especially when we look at the continued good trends in corporate profits. A number of growth-sensitive asset classes like Asian equities and emerging market equities became significantly cheaper during the course of 2018, and now offer good value on a tactical basis.

We also think there is value in some US Treasuries, especially compared to European government bonds. And the improvement in the market value of US bonds during 2018 also meant that we have the opportunity to buy more defensive asset classes at better prices, to help us diversify. We would focus on the short duration parts of the US Treasuries and also some short duration higher quality corporate bonds.

Mike: Over the medium term, we don't think traditional equity and bond markets can deliver the kind of returns they have in the past. Most developed markets are suffering from weakening demographics, heavy debt burdens and rising protectionism. Stocks appear overpriced relative to earnings prospects, while developed market bond yields are near record lows and offer scant protection in the event that inflation picks up and triggers interest-rate hikes.

But there is a range of esoteric asset classes with limited correlation to the economic cycle, such as infrastructure, aircraft leasing and litigation finance. What drives their revenues is different to what drives traditional equities and bonds. Typically, they provide a recurring income stream that should remain largely unaffected by market turbulence.

While these are illiquid asset classes, investors can allocate to them through listed investment companies that are tradeable on exchanges. These companies have opened up a new universe of opportunities for investors wanting diversification without illiquidity. The infrastructure investment companies that we target typically offer mid-tohigh single digit returns. Many of these projects are backed by governments and benefit from state subsidies. Their revenues are largely independent of economic factors.

As for aircraft leasing, increasingly, airlines are choosing to rent planes rather than own them as it provides operational flexibility. This has led to a rise in the number of companies that lease aircraft. Regular income means these businesses are relatively insulated from economic downturns, and we think the air transport industry will remain well supported by the rising wealth of emerging economies. Our aircraft leasing investments target double digit returns.

We also hold shares in a litigation financing company, which provides funding to legal firms or claimants to cover the costs of litigation cases. The firm is incentivised to select cases with the best chance of winning, since it earns a percentage of awards handed to successful claimants. The outcomes of lawsuits are almost entirely independent of economic and financial conditions. This investment has been one of our best performers in recent years and we anticipate double- digit prospective returns.

Eoin: The path of interest rates, central bank balance sheet reduction and more general tightening of financial conditions imply that we are in for a continuation of "lower for longer" in terms of the natural real rate and the cycle peak. This implies that asset class returns are likely to disappoint investors going forward, particularly on a riskadjusted basis.

Michael: While price levels appear more attractive today, we still expect the majority of returns this year to be driven by cash flow. We also feel that focusing on areas that provide consistent income streams and are less reliant on capital appreciation to generate returns seems like a reasonable approach at this stage of the cycle.

What risks do you think remain under-appreciated, with the potential to derail markets?

Deepak: The risk with the biggest potential impact is US inflation. Faster-than-expected US inflation would force bond yields higher and undermine asset class valuations. So far, inflation trends seem to be subdued. But we need to be vigilant about this.

The second risk is that a further escalation of the trade war could impact China, Asian economies and the global system. The good news is that this risk is already well-known to the market and financial market prices already reflect the probability of this happening.

Macro and political issues will likely have a significant impact on market action going forward. Given the macro backdrop today, we believe it is important to be diversified, to be willing to ride out phases of volatility, and to be adaptive to any changes in the environment. The key thing will be to take an active approach to our asset allocation.

Mike: Looking to the medium term, we are approaching a point at which US and, by association, global growth, start to plateau before declining. This is a natural effect of closing output gaps, rising financial imbalances in sectors and economies, and the likelihood that the world's major central banks transition from accommodative to tight monetary policy. The last of these presents a key test for investors: how to generate returns as stimuli end and rates rise?

Stimulus in the US has ensured its growth cycle is out of sync with the rest of the world. This led to a divergence in monetary policies, with the Fed tightening as other central banks remained in easing mode or on hold.

A continuation of this monetary tightening could cause challenges for credit markets, especially given weaker lending standards in recent years and current low spreads on corporate bonds and loans. This, in turn, could lead to a re-evaluation of the valuation of equities where share prices have benefited from issuing cheap debt to buy back shares.

Political uncertainty and an escalation in the trade dispute between the US and China pose additional market risks. If we see a sharp deterioration in US-China trade relations, security and the transfer of technology and intellectual property, that could send the global economy into reverse and decimate asset valuations. Investors would need to take cover.

In a similar vein, if far-right parties in nations such as Italy and Poland mobilise collectively and confront Brussels, it could threaten the future of the eurozone. That would be extremely challenging for European assets.

Internally in China, how authorities deal with the nation's debt overhang, economic rebalancing and RMB depreciation will be market triggers to watch. Still, policymakers operate in a largely closed capital account system. Even if China's economic growth is slowing, authorities can pull on fiscal, monetary and regulatory levers to safeguard stability.

But in the face of prevailing uncertainties, we advise investors to adopt an active management approach and search for diversifiers to help safeguard portfolios from volatility.

Eoin: There are a number of under-appreciated risks, including climate change, credit default and recession. The first of those is a multi-decade game-changer unless addressed appropriately, but there is every chance that markets will continue to turn a blind eye.

While default rates currently remain at historic lows in the main markets, there is a sense that the strains are beginning to show, particularly in the face of massive demand for refinancing. Lastly, the consensus is clearly that 2020 is the favoured candidate for the year of our next recession, but there is every chance that we could be there before then.

Michael: Geopolitical uncertainty is the highest it has been in years with trade tensions being the most significant macro risk. There is seemingly bipartisan support in the US to challenge China on its trade practices, meaning these frictions are likely to persist. Our expectation is that this will remain one of the most significant risks in 2019, one we are closely monitoring. We are also paying close attention to earnings guidance this quarter on the potential impact these trade tensions are having on global businesses.

Additionally, much uncertainty remains around the direction of Brexit, and the risk of European fragmentation appears much higher today than in previous years. Add on the government shutdown in the US and it is clear that political risks are going to remain elevated. The implication of all this is likely higher volatility even if the growth backdrop remains sound. We continue to advocate a high degree of flexibility and diversification to better manage these macro risks.