Solid backdrop, but expect more volatility
Best ideas: Emerging markets would likely benefit if the Fed remains dovish, since the dollar would likely weaken. We’re looking at opportunities via reasonably priced, quality defensive growth areas such as health care. We also like income-producing assets with low correlation to the global equity market, such as U.S. consumer staples.
The macro backdrop still looks reasonable for stocks. In the U.S., low unemployment, strong consumer sentiment and higher productivity should allow the economy to absorb the impact from higher tariffs. Globally, we think valuations look decent and don’t believe we’re heading for either an economic or earnings recession. But market volatility will likely continue to remain elevated until the trade situation becomes clearer.
The concern is that downside risks appear to be growing — especially when it comes to the effects of tariffs on corporate and consumer demand. We are also concerned about weakening corporate earnings expectations. And should recession risks grow, equities as a whole would, of course, come under more pressure. The good news is that the Fed has signaled a willingness to cut interest rates if economic or financial conditions deteriorate.
To some extent, this backdrop suggests that investors may want to consider more defensive positioning in equity markets. But traditional defensive areas look too expensive to us. Instead, we think a sort of “barbell” approach might make the most sense.
About that barbell: We think some traditionally higher-risk areas of the market look like good opportunities, especially when it comes to emerging markets. This area of the global market is more attractive than it was six months ago and would benefit from a more dovish Fed. India looks especially attractive, as it should benefit from economic reforms. At the same time, we suggest a focus on reasonably priced, quality defensive growth areas such as health care services companies or those companies that can dominate their markets and establish pricing advantages. And a consistent theme for us is investments in companies that are truly focused on responsible environmental, social and governance factors that can add to their competitive advantages.
On the private equity side, private markets have stabilized after the extreme market volatility in the public markets during the fourth quarter of 2018. Credit quality remains solid, with low historical default rates and generally good revenue growth in private equity owned businesses.
Yields and credit spreads are likely to remain volatile
Best ideas: Diversified income from flexible multi-sector strategies look well positioned to capitalize on near-term volatility. We have a particular focus on asset-backed securities and emerging markets debt, mainly in economies more insulated from tariff impacts.
Although the Fed has recently signaled a more dovish approach to monetary policy, we expect U.S. Treasury yields to remain largely range-bound. Economic growth is likely to remain moderate (despite fears over yield-curve inversions). But trade war rhetoric and complicated Brexit negotiations will likely mean that global interest rates and credit markets will experience continued volatility in the near term.
Overall, we are biased toward what we would call “late-cycle, defensive positioning,” while still looking for select opportunities to add yield to portfolios.
The high yield sector performed quite well during the overall risk-on rebound in early 2019, and we continue to see opportunities in the asset class for longer-term investors. Nonetheless, we think spreads in some sectors (especially in select energy, retail and health care) could remain under pressure. We think many areas of the U.S. credit markets look stretched, leading us to favour increased diversification to non-U.S. investments, especially in emerging markets debt. Within the U.S., we also continue to like preferred securities and asset-backed areas of the market, particularly around themes supported by still-resilient household balance sheets.
Private credit markets remain supported by healthy revenue growth, but middle-market high yield issuance is down significantly. We continue to see strong competition for deals across traditional private investment grade debt transactions with strong relative value and solid covenants; although broadly syndicated deals have been significantly over-subscribed and spreads are compressed.
So what are some of the key risks on our minds? If the Fed doesn’t match market expectations for rate cuts against stable employment and inflation data, credit sectors could under-perform against a more hawkish outlook. Additionally, emerging markets could come under renewed pressure if trade rhetoric intensifies and the dollar strengthens.
Municipal technical imbalance could boost performance
Best ideas: Longer-term municipals have outperformed this year, a trend we expect will continue. We also think high yield municipals look attractive. This area of the market should benefit from still-wide spreads and sector-specific factors such as opportunities in land-secured bonds, which look particularly appealing as active first-time buyers keep inventories low.
The municipal market has shown solid performance so far in 2019, and we expect that trend to continue. The municipal-to-U.S. Treasury yield ratios have declined so far this year, and while municipal credit spreads have widened, that has been mainly due to new entrants into the municipal marketplace rather than rising default risks. Overall municipal credit quality also remains sound. Defaults remain low while credit upgrades are consistently exceeding downgrades, with numerous upside surprises to state-level revenue collections versus budget in the first quarter of 2019, including California, New York, Connecticut and Illinois.
Even beyond these fundamental factors, municipal bonds look attractive from a technical perspective: Demand is strong and supply is tight. Municipal fund flows have remained strong so far in 2019, especially as investors have become more comfortable with longer-duration investments. New issue supply has been short of expectations, failing to keep pace with coupon payments, bond calls and maturing bonds. We expect this trend to continue and increase over the summer months. We also expect net negative new issuance for the year, which should further benefit municipals from a technical perspective.
So what could go wrong? The biggest risks we see for municipals are the possibility of a more hawkish stance from the Fed and/or a rise in inflation. Either or both of these scenarios could cause municipal bonds to falter. Additionally, investors always need to be on the lookout for possible credit events (which is why we think an intense focus on credit research remains warranted). And finally, there is some concern that segments of the municipal market may be overvalued, but we think ample opportunities remain available, especially for those investors who can benefit from the after-tax advantages of municipals.
Late-cycle strategy focuses on defensive asset classes and finding value
Best ideas: We think investments in the agriculture sector in the U.S. and globally appear well positioned and represent an attractive defensive investment. Alternative commodity markets using proprietary, trend-following strategies have possible advantages of capitalizing on pricing inefficiencies. In public markets, we favour U.S. waste investments given their strong fundamentals, defensive nature and outlook for growth, and also like Australian real assets as a defensive investment poised to benefit from a monetary policy tailwind.
Heightened geopolitical risk has been the critical theme since March. Escalation in the U.S./China trade war, further upheaval in Venezuela and heightened tensions between U.S. and Iran are contributing to greater levels of uncertainty and volatility across public and private real assets. In the private space, U.S. row crop returns remain under pressure due to continued weak commodity pricing and tariff-related headwinds. U.S. timberland returns continue to lag, but growth in emerging markets is a bright spot. In public markets, areas less tied to economic activity across asset classes have been doing well, and we think that trend should persist. Overall, we have been focusing on defensive positioning and select value opportunities across public and private markets.
In private markets, major agricultural commodities including wheat, soybeans and sugar continue to be pressured by plentiful supply driven by favourable growing conditions. While it varies by market, row crop farmland values across the U.S. remain weak. Soybeans have been pressured by the U.S./China trade war, and would stand to benefit on any resolution. Demand for wine from top-tier regions and land appreciation driven by Silicon Valley entrepreneurs has contributed to the continued strong performance for viticulture assets. The agribusiness sector continues to be under-invested, but should benefit from long-term consumer trends toward healthier eating and demand for healthy proteins.
While U.S. returns continue to lag, timberland investments in emerging markets (or in regions that serve them) represent good opportunities. Increasing per capita income in middle-income countries will increasingly spur demand for wood products. As global markets grow more competitive, we continue to focus on low-cost pulp-producing regions such as Brazil and Uruguay.
In public real assets, we’re seeing good opportunities in defensive sectors, such as listed infrastructure, utilities and REITs. These areas are regaining favour following a period of under-performance as investors pursued more cyclical exposures. A more dovish interest-rate environment would further support these areas of the market. Within public real estate, fundamental demand for residential, office and industrial space remains strong, while the shift away from physical retail space continues, resulting in lower pricing power. Niche sectors with less cyclicality and consolidation opportunities such health care, waste and student housing all look like good options.
In commodity markets, energy investments have benefited from heightened geopolitical risk experienced during 2019, but supply-side risks outside North America, particularly in Venezuela, Iran and Libya, have increased since 2018. Overall, commodities stand to benefit from an expanding global economy, but in the event of a slowdown in financial markets, we think they may provide better relative performance compared to traditional asset classes.
Regarding risks to our outlook, a resurgence in economic growth could lead to higher rates, and would likely create a move away from certain real asset sectors, as real assets can be more vulnerable to interest rate spikes than broad markets. Surprise disinflation and broad U.S. dollar strength could also provide headwinds to commodities and international investments.
Opportunity exists amid a more defensive stance
Best ideas: We favour investing in a wide range of “global cities” that offer scale, growth, sustainability and resilience. In particular, we favour opportunities across all forms of housing driven by the long-term demand/supply dynamics of the sector, as well as investments in real estate debt.
It is widely assumed that the real estate sector is in the later stages of the economic cycle. However, allocations to property sectors continue to grow, aided by continued geopolitical and financial market uncertainty. Amid such a backdrop, investors turn to real estate due to its overall stability, the strength of the income it produces, its diversification attributes and the ability to unlock and enhance value through active management.
Buoyed by accommodating monetary policy, we expect slowing economic growth rather than a recession. This may transcend into cooling real estate valuations due to late-cycle dynamics, but importantly, the two main historic drivers of corrections in property valuations — over-supply and excessive debt — do not appear present as risks. So in a world starved of yield, income potential from real estate should remain an attractive prospect.
That said, at this stage of an elongated cycle, we think it makes sense to focus on more defensive areas of the market. The retail sector faces structural challenges, but by embracing change and delivering quality, we think investors can still find good long-term opportunities. Commercial real estate debt also presents attractive risk-adjusted opportunities.
Elsewhere, we continue to believe in the broad themes of sustainability, technological innovation and specific cities poised to benefit from evolving demographic and economic trends.
We are also looking to capitalize on the evolving requirements of real estate tenants, such as the expansion of flexible working practices that are causing both disruption and opportunity.