How does growth, inflation and real rates influence portfolio strategy in uncertain and changing times?

This is our final article of three aimed at providing advisers with a framework around asset allocation that will assist with client discussions and portfolio strategy in these uncertain and changing times.

In our first two articles (CPD: The importance of growth regimes to asset allocation decisions and CPD: The importance of inflation regimes to asset allocation decisions) we examined the influence of first growth, and then inflation and real rates on asset returns. In this article we explore the interaction between these factors and how this can be used to help deliver a better asset-allocation outcome. We also look beyond traditional assets and extend our framework to alternatives – opening new ways to seek both returns and portfolio diversification in a world where government bond yields remain at the lower end of their historical ranges.

Recapping our growth and inflation frameworks

When assessing growth dynamics, one of the best sets of timely indicators is the purchasing managers’ indices (PMIs), which reflect the health of an economies manufacturing and service sectors. A carefully selected group private sector companies are surveyed, providing valuable insights into the underlying trends being experienced in each sector. Data is then aggregated into a PMI index for the economy as a whole – a score above 50 indicating that activity is improving, and a score below 50 indicating contraction. For inflation, we look at both the current rate of inflation, as measured by a country’s consumer price index, and the expected future rate of inflation, as measured by breakeven inflation^[1].

From a growth perspective, the sweet spot for risk assets has historically been an Accelerating growth regime (A). During these times, the correct asset-allocation strategy has been to skew towards pro-cyclical exposures such as equity markets. The Falling growth regime (C) is the only one in which average equity market returns have historically been negative. Volatility tends to be much higher when PMIs are sub-50 (regimes C and D) and the historic range of drawdowns seen in regime C are more extreme than in any other growth regime.

When we extend our framework to assess the impact of inflation, one finding that seems somewhat counterintuitive is the extent to which higher CPI, breakevens and real rates appear to be the most constructive environment for risk assets, such as equities. Regime E, where both inflation and real rates are rising, has historically been the best environment for equity markets while regime H, a combination of sharply falling rates and inflation has historically been the worst environment for risk assets. In regime E, returns are often negative; equity drawdowns are worse than in any other environment and equity volatility is highest. With this backdrop it is unsurprising that regime E is also historically the best regime for government bonds and investment grade credit.

When we combine regimes, it allows more nuanced analysis

Combining the growth and inflation view helps to clarify not only what the prevailing environment means for an asset’s performance but also how those prospects may change as economic conditions evolve.

For example, for equities, a shift from an Accelerating growth environment to a Moderating one clearly implies a move to a less impressive (though solid) backdrop for equity returns. However, if growth is still robust enough to keep inflation rising then the risk-adjusted returns potentially on offer remain favourable – especially if the cost of capital (real rates) is falling at the same time (see Figure 2, combined regime B2).

On the other hand, if a shift from Accelerating growth to Moderating occurs against a backdrop where inflation and real rates are also declining sharply, there is a risk that the environment is sufficiently weak that this is simply a step in a transition to a Falling growth regime. Falling growth regimes are the worst environments from an equity perspective (combined regimes C1 to C4) – historical returns and drawdowns have been particularly unappealing regardless of the direction of inflation and real rates.

We can also see from Figure 2 that rising growth environments (generally where economies are recovering from recession) tend to be associated with the most spectacular equity returns – but the amount of time spent in these regimes is fleeting. Indeed, identifying such periods is akin to ‘buying stocks at the bottom’ – an easy concept to grasp but somewhat harder to execute in practice.

Extending our framework to other asset classes

As the most volatile of the mainstream assets within a multi-asset portfolio, understanding the likely performance characteristics of equity markets is at the forefront of our thoughts. However, we can use our framework to assess a range of both traditional and alternative assets.

While growth is the most important for equity market returns, for commodities it is the direction of inflation that matters most (see Figure 4). The top four regimes for commodities are those where inflation is rising, while the four worst regimes are when inflation is falling. This is intuitive given the intrinsic linkage between commodity prices and inflation, but it serves to reaffirm the usefulness of viewing assets within an economic regime framework.

Similarly, for the trade-weighted dollar (Figure 5) the most dominant driver is the direction of real rates. This is once again an intuitive result as high real interest rates act as a natural draw for international capital seeking the most attractive returns.

Looking beyond traditional asset classes

To access a truly broad opportunity set, we believe that a multi-asset strategy must take a flexible approach that gives access to both traditional, directional assets and alternative, less directional assets. With government bond yields towards the lower end of their historical ranges, alternative strategies can offer opportunities from both a risk mitigation and return generation perspective – offering a different way to add diversification at a time when traditional sources of diversification may prove less reliable than in the past. The asset allocation framework described in this article can be just as applicable to these alternative strategies.

To illustrate, in Figure 6 we compare a range of alternative diversifiers across two of the regimes in our growth framework. These include equity factor-based strategies (momentum, volatility, quality buybacks vs dividends as well as value/growth), traditional relative value trades (developed markets versus emerging markets, credit spread compression and equities versus bonds) as well as traditional hedges (option strategies, defensive currency strategies and government bond and yield curve trades). All factor-based strategies are based on US equities and use the broader US market as their funding leg.

Looking at their historical performance, the classic factor-based strategies such as ‘value versus growth’ appear to offer little from a regime perspective although cyclicals versus defensives behave in a logical manner. Hedging strategies tend to be a drag on performance in accelerating regimes (which is when risk asset returns are greatest) but perform well in a moderating regime.

In the current environment, with government bond yields still at low levels and with inflation uncertainty high, alternative strategies such as developed versus emerging market equities or defensive currency trades, can offer different ways to diversify a portfolio rather than relying on traditional assets such as government bonds.

Conclusion

Across the three articles, we have shown the importance of growth, inflation and real rates within an asset allocation framework and the importance of the interaction between them. The dominant influence within the growth and inflation mix differs significantly across asset classes. While growth is the most important for equity returns, the direction of inflation matters most for commodities and real rates for the US dollar. Regimes that are highly positive for certain asset types, can be the worst regimes for others.

Although the pandemic was brutal in terms of the size of economic drawdown and the rapidity in which it took place, the recovery has, so far, followed the same trajectory as historical precedent. This has reaffirming our belief in the clarity of our framework as we look to the new growth and inflation challenges we expect in the post-pandemic world.

We trust that this series of three articles has been a helpful reference point for discussions with clients on portfolio strategy. We are working on a research piece on the importance of assessing financial conditions and look forward to sharing that in due course.

By Matthew Merritt, Head of Multi-Asset Strategy Group

Read part 1: CPD: The importance of growth regimes to asset allocation decisions

Read part 2: CPD: The importance of inflation regimes to asset allocation decisions

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Notes:
[1] Source: For illustrative purposes only
[2] A consumer price index measures the rate of change in prices for a basket of goods and services that are typically purchased by households, breakeven inflation is the rate of inflation at which a country’s nominal government bonds would generate the same return as inflation-linked government bonds. This gives us the level of future inflation that markets are currently pricing in.
[3] Ibid.
[4] Ibid.
[5] Ibid.
[6] Ibid.

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Matthew Merritt

China the outlier in U.S. trade war negotiations

“Although the US economy is expanding at a firm rate, global trade has been a significant concern for investors particularly as growth outside the US has already decelerated since then beginning of the year.

The US has been able to strike new trade deals with some of the countries it appeared to have fallen out with, or agreed to further talks without the imposition of tariffs in the meantime. Canada and Mexico are the obvious examples, but the EU and Japan also fall into this category.

But the approach to China is clearly somewhat different – an apparent attempt at isolation, with large negative measures already implemented and the threat of more should China not give significant ground in short-order.

The outcome will clearly depend on just how painful the slowdown in trade volumes becomes (for both sides) and the US mid-term election result may have some bearing on this”, says Matthew Merritt, Head of Multi-Asset Strategy Team.

Global Investment Grade Credit

Peter Bentley, Deputy Head of Fixed Income and Head of Global Credit notes : “Fundamentally, credit markets continue to be in good shape, but as the credit cycle continues to mature and M&A activity continues to be popular, caution is warranted.

Although we believe valuations are somewhat stretched, we do not see catalysts for material weakness on the near-term horizon. Therefore a close-to-neutral position seems appropriate (rather than a costly outright short), and a focus on targeting relative value between different sectors, industries and issuers within the global credit universe could be the most appropriate strategy.

In a potentially range-bound environment, we believe stock selection will be key to outperformance. Investors may also benefit from opportunities to implement relative-value trades between cash bonds and credit default swaps, or CDS – the so-called ‘basis trade’.

Given bouts of volatility, CDS could be deemed more likely to track price moves in equity markets to a greater extent than cash credit, potentially creating temporary divergences in pricing.”

Emerging markets debt

Colm McDonagh, Head of Emerging Market Fixed Income writes “The year-to-date weakness across emerging market debt has led to an improved valuation proposition.

The sell-off has, at times, been indiscriminate, meaning that pockets within the emerging-market complex have weakened without underlying fundamental justification. Investor positioning is also lighter, with both ‘crossover’ and dedicated investor positioning underweight.

China has the means to continue serving as the anchor for wider emerging markets – while Chinese growth has been slowing, the authorities have responded with domestic policy easing and by maintaining relative currency stability.

If this succeeds in stabilising domestic demand, we could see similar stability in terms of fixed asset investment, which in turn would lead to improving commodities demand. Argentina, Turkey and Brazil have made some headway of dealing with their frailties, as have other emerging markets, and we believe this too should contribute to greater stability for the asset class.”

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Matthew Merritt

Market and economic review

Markets: profit-taking in equities while the US yield curve continues to flatten

Stocks were buoyed at the start of the week by progress on the US tax bill, but equity market gyrations were the most notable feature of the week as profit-taking on year-to-date winners continued to be an obvious theme. Asia Pacific markets in particular were softer, with weaker commodity prices and fears of tighter financial regulation in China weighing on sentiment until better macro data, released on Friday, allowed markets to bounce and stage a partial recovery. Movements in other risk assets were much more subdued. Government bond markets performed well with yields moving lower while, in the US treasury market, curve flattening continued to be the dominant theme.

Data: global PMIs highlight broad growth

The start of the week saw the release of final November purchasing manager’s indices (PMIs) across a raft of countries. Aggregating the indices for the 31 countries that we follow, 27 showed improvements while moderation was seen in only four – a clear indication of the breadth in the current cyclical upturn. The end of the week saw Japanese GDP surprise on the upside while Chinese trade data was strong with both exports and imports higher than expected. The week ended with the US labour market report: non-farm payrolls came in marginally ahead of expectations while the unemployment rate held steady at 4.1%, which was in line with forecasts. Given the strength of the labour market, wage data was always going to be a focal point and, once again, average hourly earnings came in below expectations.

Politics: progress on a number of fronts

In Germany, the Social Democratic Party conference voted in favour of allowing its leader to engage in coalition talks with Angela Merkel’s Christian Democratic Union party, which could end the current political impasse and thereby avoid the need for fresh elections. In Brexit negotiations, Friday saw a breakthrough over the North-South Irish border issue, which was the sticking point in agreeing the ‘divorce settlement’. Negotiations can now move onto the second stage, which will focus on trade and transitional arrangements. Over in the US, a partial government shutdown was averted as both the House (235-193) and the Senate (81-14) voted in favour of extending government funding for two weeks until 22 December.

Outlook

Inflation and central banks take centre stage

The week ahead will see the release of a raft of inflation data from a range of key countries. The US CPI release on Wednesday is the clear highlight. The lack of inflation around the world has been the source of much debate in 2017. Last week saw US Q3 unit labour costs revised down following a downward revision to wage income in US national accounts. Against that background, the Federal Reserve meeting on Wednesday 13 December will be closely watched. The market has fully priced in a 25bp hike, which would be the third this year. At its November meeting, the Federal Open Market Committee upgraded its description of the economic growth to “solid” from “moderate” and little of the intervening data would have caused them to change that assessment. Attention will be focused on any adjustments to their economic forecasts, and signals as to their thinking on the inflation conundrum. Jerome Powell takes over as chair when Janet Yellen’s term expires in February.

The Bank of England (BoE), the European Central Bank (ECB) and the Swiss National Bank also have their policy meetings next week (on Thursday). The BoE is likely to remain on hold after it hiked rates last month for the first time in a decade. No change in rates is expected by the ECB, and the market is not expecting any additional guidance on the likely path of quantitative easing withdrawal. However, it will release its economic forecasts through to 2020.

Brexit decision

European Union (EU) leaders will formally decide at a summit next week whether there has been sufficient progress on the UK’s EU exit terms to allow the start of the second phase of the negotiations, which will focus on trade and the transitional period. Commentary today suggests they will give the go-ahead, but exploratory talks on the future relationship are unlikely to begin until next year.

Taxes and President Trump

Members of a special committee merging bills from the Senate and House are aiming to enact a version of President Trump’s tax reforms before the Christmas break, but without Democratic support they need almost total unity in order to pass legislation. US foreign policy will also remain in the spot light, following elevated tensions in the Middle East last week.
The value of investments and any income from them will fluctuate and is not guaranteed (this may be partly due to exchange rate fluctuations). Investors may not get back the full amount invested. Past performance is not a guide to future performance. Unless otherwise attributed the views and opinions expressed are those of the fund manager at the time of publication and are subject to change. The content of this document is valid for one month from date of issue.

By Matthew Merritt, Head, Multi-Asset Strategy Team

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Matthew Merritt

Political uncertainty is looming over financial markets. The spectre of further events on the Korean peninsula, the threat of a US debt crisis, and the ongoing Brexit negotiations all present significant challenges for investors. However, markets have generally performed well year-to-date on the back of strong economic growth and low inflation.

In our view, recent economic data, coupled with recent central bank rhetoric and activity, present a reasonable backdrop for risk assets, while we expect government bonds to remain an effective diversifier – at least in the near term. Our rationale for such an outlook is laid out below, along with our views on the outlook for volatility, currency markets and real assets.

We believe an effective multi-asset portfolio should consider investing beyond mainstream equity and bond markets. By incorporating holdings that are less sensitive to overall market direction, a portfolio can access a broader range of risk premia, enabling a degree of diversification which traditional strategies cannot match.

Strong growth and low inflation

Markets have been driven in recent months by a global cyclical upswing (illustrated by Insight’s global cyclical momentum monitor in Figure 1). While economic surprises have rolled over and some economic data has moderated in recent months, financial conditions have eased and this suggests that any slowdown may well be delayed.
 

Figure 1: Insight’s global cyclical momentum monitor

Source: Bloomberg, Thomson Reuters and Insight as at 5 September 2017.

Growth has been particularly strong in the eurozone and the US, while inflationary pressures have been far more muted than expected. For example, wage growth in the US remains low relative to historical levels.

We therefore continue to expect reasonable growth to be achieved around the globe without it leading to a significant pick-up in inflationary pressure. If this is right, then adjustments to central back policy, most importantly at the Federal Reserve (Fed) and European Central Bank (ECB), are likely to be gradual and aimed at financial stability, as much as keeping inflationary pressures in check.

Linked to that, the unwind of the Fed’s balance sheet – initially by slowly stopping the reinvestment of money earned on bonds bought via the quantitative easing process – should be a well signalled and steady affair. In Europe, the relative strength of key activity numbers suggests it won’t be long until the ECB starts to taper its bond purchases and reduce the size of its balance sheet. 

Risk assets

From a broader asset allocation perspective, whether there is a continuation of the coordinated global growth/low inflation story that has emerged over the last few quarters is key for the performance of risk assets – geopolitics notwithstanding.

The better performance of risk assets over the last year has reflected the improving growth backdrop and strong corporate earnings in both the US and Europe. How long this trajectory can be maintained is unclear but we expect equity markets to remain highly sensitive to the prospective growth outlook.

Beyond a relapse in growth expectations, could a rise in bond yields derail the party for risk assets? Our analysis above as to the likely path for Fed and ECB activity suggests that adjustments to both the Fed’s and ECB’s balance sheets may ultimately give yields an upward bias – but the longer end of yield curves should be supported as long as inflationary expectations remain well anchored. We would expect a well-behaved government bond market, combined with solid but not spectacular economic growth, to continue to provide a reasonable backdrop for equity and credit.

Defensive assets

The role of defensive assets, namely government bonds or cash, ultimately depends on their likely behaviour in relation to the other assets in a diversified portfolio.

Over the summer, an apparent reassessment of central bankers’ views on monetary policy led to short-term sell-offs in equities and bonds, but over the medium term we think the future path of rates will depend on the trajectory of growth and inflation. As noted above, we believe the growth backdrop and trajectory of central bank policy is sufficient to suggest slightly higher yields, but the lack of inflationary pressure indicates government bonds will retain a place as a diversifying asset at least in the near term. Cash, volatility and real assets are alternative diversifiers should inflationary risks build.

Volatility

Clearly, markets struggle to cope with the probabilities associated with geopolitical risk, but recent bouts of volatility have been relatively short-lived and muted. While the VIX Index fell to 10-year lows in July, the worsening situation in North Korea caused it to spike to a 2017 high of 16 in August. While this level appears high compared to the recent past, it is only in line with the average value for 2016.

More sustained increases in volatility are usually the result of economic slowdowns. Unless we see ongoing threats of military escalation, renewed concerns regarding China, or central banks aggressively tightening monetary policy, we believe volatility is likely to remain low. As for the threat of a US debt crisis, even if there is ultimately a shutdown, we would not expect a significant impact on the economy or financial markets – shutdowns tend not to last very long due to the public backlash.

Generally, we view volatility spikes as a potential opportunity to profit from any dislocations in asset prices. Currently in equity-land, relatively low levels of index volatility are not only due to low single stock volatility, but also due to low levels of correlation between stocks and we do not see low volatility as necessarily being a sign of complacency.

Currency

We believe European macro variables are unlikely to continue their recent outperformance, but we expect the euro to remain firm over the short term, which would weigh on European equity markets. By contrast, the lack of any progress on Brexit negotiations suggests UK stocks should continue to benefit from sterling weakness over the next few months.

Real assets

Commodities have mixed drivers with rising cyclical demand being offset by supply headwinds. Fading global inflationary forces mean that the hedging attraction of the asset class has fallen. We believe selected asset-backed securities in high-grade residential paper are attractive. The asset class has received significant inflows but spreads versus investment grade credit remain attractive.

As for infrastructure, we believe exposure to selected infrastructure securities with an operational bias, and strong and stable long-term cash flows, will continue to act as effective diversifying assets.

How to position a multi-asset portfolio

From an asset allocation perspective, diversification is normally associated with investing across a range of asset classes, but we believe effective diversification involves combining different sources of return. By blending the active management of directional risk (making money when markets go up) across a range of assets, with less directional strategies (which aim to make money whether markets go up or down), it is possible to take advantage of a broader opportunity set, enabling return generation across a range of market conditions.

Less directional strategies might include relative value positions, which favour one market or financial instrument over another; or strategies that perform if a market either remains within a specified range or breaks out of it.

We believe that blending the active management of directional risk with less directional strategies, and having wide flexibility to change levels of exposure across the investment universe, can help to deliver a smoother investment journey and provide a better distribution of returns – both of which are essential to achieving attractive medium-term growth with lower volatility than equity markets.

By Matthew Merritt, Head of Multi-Asset Strategy Group, Insight Investment

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