Columbia Threadneedle: Asset Allocation Update

31 jul 2019

Each of the US, UK and European yield curves is inverted at the short end – that is to say that investors have nailed into market valuations the certainty that overnight interest rates controlled by major central banks will be lower than they are today over the next two years. In fact, in the US the bond market has priced in the certainty that interest rates will be lower than they are today over the next 10 years. And UK and European bond markets are pricing the expectation that central banks will need to keep interest rates below the rate of inflation indefinitely – a policy that might historically have been associated with expectations of an economic depression.

So why are equity markets rallying at a pace that typically presages global economic boom? One view is that equity markets are larger and contain forward-looking information about thousands of individual firms; they aggregate the wisdom of crowds. Put simply, this view is that equity markets are smarter. Going down this avenue of thought leads us to the conclusion that bond markets are just plain wrong, that the economic data is on the brink of troughing, and that the resolution of near-term trade uncertainties will unleash a powerful and reflationary economic expansion in the second half of the year.

This view may prove prescient. The most significant product of this view would be that either the bond market or the stock market is set for a meaningful fall. If the “stock market view” was right, you could only make money from it by selling bonds in the expectation that they were due heavy falls (as it would already be captured in the price of stocks). If the ‘bond market view’ was right, you could only make money from it by selling equities in advance of their collapse (as the view would already be captured in the price of bonds).

This is the sort of pricing discordancy that cross-asset investors like me love, as it allows them to position portfolios to outperform without having to build a view as to how the future is most likely to develop. But we don’t need to believe that cognitive dissonance rules the pricing of the largest and most liquid financial asset markets in the world. There is an environment for which stock and bond markets look consistently priced. Imagine an environment in which central banks cut rates enough to avoid recession but are unable to deliver the sorts of inflation that would allow interest rates to be raised in the foreseeable future.

In such an environment the outlook for earnings growth would be bleak, and those stocks able to grow their top line through their exposure to new markets or their ability to eat market share would attract a much higher multiple than those firms that rely on broader economic growth to flourish. The amount of additional yield large firms with successful and diversified businesses, as well as strong financial statements, have to offer to attract debt finance needn’t soar in this environment, but distressed borrowers needing an upturn in economic growth to survive would not do well. Let’s call it the Japanification of the world. This environment is not too far from that being priced by both bond and equity markets.

Even if the Japanification of the world may not sound far-fetched, there are risks to this view becoming reality. These risks take two principal forms. Firstly, an earnings recession would likely unseat equities. As already noted, economic growth is slowing and company analysts are revising down their earnings expectations for 2019. Company analysts have not yet revised down their 2020 earnings expectations, and sustained economic weakness could deliver softness in market returns from here. Secondly, absent earnings growth, equity prices have been rising because earnings multiples have been expanding, and multiples look to have been expanding largely because bond yields have been falling, given the weaker economic environment. It remains to be seen whether multiples could remain at historically high levels if the four rate cuts that are baked into US Treasury bond valuations failed to transpire.

Commodity markets have tracked the rebound in risk during the first half of the year, which is an encouraging sign insofar as they tend also to track growth. But given the softness in forward-looking macroeconomic indicators, we have decided to move from favour to neutral, in keeping with our weak but positive growth outlook.

The narrow path in keeping with robust markets may well be navigated successfully. We see enough value in outstanding companies that we are – despite the risks discussed – market-weight equities. But in recognition that risks of a misstep are higher than usual, we have reduced the overall amount of portfolio risk taken in total return asset allocation portfolios and look for opportunities to add when a more substantial risk premium is offered across asset classes.