Global growth faces two major geopolitical threats. The US-China trade war and the rise of populism in Europe have ushered in a new era of market sensitivity. But beyond short-term fluctuations, are they having a significant impact on growth?
Earlier this year, China and Europe both displayed tentative signs of stabilisation, but recent data has failed to confirm the expected pickup in activity. While this may appear to be linked to macro events, investors need to distinguish the impact of political developments on market volatility from their impact on growth, to understand the implications for asset allocation.
A structural shift
The US-China trade war has been a game-changer. It has challenged the established order of trade relations and opened a ‘Pandora's Box' of renegotiations from which the most hopeful outcome will not be a return to the globalised world order.
This structural shift has ushered in a new paradigm of renewed market sensitivity. Additionally, the recent escalation in US-China tensions has increased downside risks and added uncertainty headwinds to the growth outlook. While we believe rationality will ultimately prevail, the tail risk has also grown whereby national pride will become the main driver in negotiation processes.
In Europe, the rise of populism is ubiquitous, evidenced by recent European Parliament elections and the ongoing Brexit saga.
However, beyond the impact on short-term volatility, only two things are relevant for markets. The risk of eurozone breakup is the biggest threat, followed by the risk political consensus could lead a country to depart from the Maastricht framework of low fiscal deficit and public debt.
Even Italy, which occasions endless investor worry, displays very low risk of either. If a new Lega and centre right government came to power, the probability it would completely ignore the European framework is relatively low. Italy still has the support of the ECB, and Salvini's rhetoric is more performance than substance. Therefore, we are not too concerned by the impact of granular political developments in Europe on growth.
Our base case scenario remains one of slower but positive global growth, reminiscent of the situation in Japan. Things might get worse before they get better - and eventually settle at a less optimal level - due to the seismic shift in global trade relations. However, no recession, low growth and low inflation are maintained by accommodative central bank policies and strong domestic demand across the world.
Anticipating a lower growth equilibrium, we have taken steps to protect our multi-asset strategies. In the current environment, traditionally defensive assets, such as gold, are expensive. So rather than increase exposure to these safe havens, we are seeking shelter by reducing current holdings in riskier assets. We have opted for decreasing equities, which are more sensitive to negative news flow and sentiment than other asset classes and will bear the brunt of increased volatility.
We are also refraining from taking duration risk on US treasuries, essentially on valuation grounds. Given our belief a recession is unlikely, we think the recent drop in long-term yields has probably been excessive, and, in any case, presents little value compared to the carry offered by shorter-term bonds. By staying invested at the front end of the curve through one-year US treasuries, we can obtain 2% guaranteed return on a highly liquid investment, without incurring risk of capital loss.
Elsewhere, dovish monetary policies have chased away liquidity concerns which plagued investors in Q4 2018, providing support to riskier fixed income assets. Therefore, to generate returns in this lacklustre growth environment, we are looking for carry in riskier credit segments.
We are currently finding value in emerging market hard currency debt, where spreads are attractive and currencies stable for the time being. Assuming weak growth and accommodative policies continue without a recession into the next 12 months, there are no visible headwinds for EMs. Liquidity is abundant, local currencies will not be devalued by a strengthening dollar, and defaults will remain limited.
We are targeting a diversified exposure to the emerging space, looking to countries less exposed to macro risk - avoiding South East Asian economies linked to China - and free from idiosyncratic weaknesses. Latin American countries, such as Brazil, and Eastern European countries with euro-denominated bonds and attractive pickup, such as Poland and Romania, are the most appealing.
European subordinated financials with sound balance sheets also offer attractive carry at cheap valuations, supported by accommodative monetary policies which should prevent further spread widening. Nevertheless, we approach the asset class issuer by issuer to identify positive risk-return profiles.
Given our belief a recession is not imminent, we are avoiding expensive safe havens and keeping our allocations flexible. By staying nimble and adjusting allocations to reflect the shifting paradigms of heightened volatility and stagnating growth, we are still able to unearth pockets of value in the current sluggish environment.