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Charting Investment Route Amid Uncertain Times: The Kleinwort Hambros View

Fahad Kamal, 7 June 2019

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The UK private bank scans traditional and alternative assets, assessing where it thinks it should be best positioned in the current environment.

In times of uncertainty making the right judgement calls, or sometimes choosing not to do anything other than sit still, are crucial. With tariff wars seemingly in the offing, and market valuations arguably getting into heated territory in places such as the US, what should investors and advisors do? To answer some of those points is Kleinwort Hambros’ chief market strategist, Fahad Kamal. This publication is glad to share these insights and invites responses. It doesn’t necessarily endorse all views of guest contributors. Email the editor at tom.burroughes@wealthbriefing.com

Equity markets have continued the upward trajectory into the spring, reversing the Q4 sell-off. Dovish noises from the Federal Reserve (Fed) have bolstered market sentiment. With inflation likely to remain muted in the US, the Fed is likely to stick with its accommodative monetary policy stance. Moreover, hopes of a trade deal between the US and China still largely hold despite blustery rhetoric from the US President. A deal would be beneficial to all parties – and is a basis for optimism despite the “noise”. 

Economic growth also remains well supported by domestic demand. In the US, job creation remains buoyant and wages have been rising steadily, while muted inflation has preserved purchasing power. Much the same is true in the UK as well. Moreover, the effects of US tax reform were felt more strongly last year, but fiscal policy will also continue to underpin growth this year. Even in the euro zone, where Treaties impose fiscal restraint, additional spending in Germany, France and Italy should provide a moderate boost to activity. Most importantly, Chinese fiscal stimulus has helped to keep domestic GDP growth north of 6 per cent, and is already leading to encouraging data on credit, PMI, inflation, trade and FX reserves. It has also helped mitigate a global slowdown.

Given the above factors - combined with reasonable valuations, positive momentum and neutral sentiment - we remain sanguine on equities. We also prefer credit risk - achieving some yield pickup - versus duration risk, and have allocations to investment grade bonds, high-yield credit and emerging market debt. Nonetheless, we remain ever vigilant: prudence is critical, particularly in a late-cycle environment. Therefore, we have begun to increase duration in our government bond holdings, inching from short-to-neutral despite expensive valuations. While government bonds offer poor value in absolute terms, the drift in yields upwards has lost its thrust across most major markets, and they continue to be critical in offsetting risks from equities; the fourth quarter sell-off in 2018 remains a recent case-in-point. Positions in gold, and alternative assets, are held for much the same reason.

Fixed Income: The hunt for yield continues
While government bonds offer poor value in absolute terms, the drift in yields upwards has lost its thrust across most major markets, and they continue to be critical in offsetting risks from equities in multi-asset portfolios. This supports our view that we should begin increasing duration in government bond holdings in most portfolios from short to neutral.

Increasing duration in government bonds, but still prefer credit
The March Fed statement highlighted “uncertainties” to justify a dovish stance. No rate hikes are scheduled this year - indeed markets suggest there will be a cut. However, recent surveys still point to robust growth, albeit less buoyant than last year, and further tightening in the job market is on the cards, while inflation expectations remain anchored. The mixed signals have led to yields on 10-year US Treasuries (UST) ranging from a low of 2.37 per cent to a high of 2.80 per cent thus far this year. 

Regardless, one thing that remains evident is a loss of thrust behind an upward shift in the yield curve, even on the short-end, which has been rising much faster than the long-end for the past few years. While government bonds offer poor value in absolute terms, the drift in yields upwards has lost its thrust across most major markets, and they continue to be critical in offsetting risks from equities in multi-asset portfolios. This supports our view to begin increasing duration in government bond holdings in most portfolios from short to neutral. 

However, we prefer credit risk to duration risk. Default rates are expected to stay below historical averages and corporate bond issuance is steady, boding especially well for US HY. In the US, refinancing of maturing IG bonds will peak in 2021 at $500 billion while the top for HY will not come until 2025 at $200 billion. Indeed, Fed rates set to remain stable and there is only modest risk of higher spreads this year. 

Gilt yields low, but defensive properties attractive 
The Brexit extension to 31 October reduces the probability of a disorderly outcome. While gilt yields remain low, we are leaning towards weighing their defensive properties more heavily at this point in the cycle. Indeed, UK gilts were deemed unattractively valued at the advent of Q4 2018, only for yields to fall precipitously during the heightened market stress and volatility that dominated the quarter. 

UK credit is valued attractively at present, biasing us towards credit risk. In the UK, HY spreads have narrowed by only 80bp – half as much as in the US and eurozone - due to lingering Brexit uncertainty.

Our core scenario is for a “soft” Brexit and so we could expect spreads to tighten further. In addition, the carry on UK HY is very attractive - spreads would have to widen by more than 275bps before generating a negative return. 

The ECB remains limited in in options 
At its April meeting, the European Central Bank remained on hold but stressed downside risks to growth. This could foreshadow further easing, though ammunition looks scarce, with rates already in negative territory. Nonetheless, with inflation pressures muted across the continent, and the ECB far from tightening, a short duration stance offers less in terms of yield or protection, similar to other markets.

Equities: brighter prospects
Chinese stimulus, accommodative central banks and some fiscal easing should translate into brighter economic growth this year. Indeed, tentative signs are emerging that the global economy is set to firm in coming months, providing fundamental support to global equities. 

US
The US economy has proven resilient so far and the Fed’s pivot in monetary policy has loosened financial conditions since the turn of the year, fuelling equity prices. However, following year-to-date strong performance, S&P 500 valuations are again well above other regions, warranting a neutral stance. Meanwhile, S&P 500 profits have been revised down sharply in recent months and are now expected to grow a meagre 3.2 per cent in 2019. The first quarter is expected to be particularly weak, before reaccelerating in the second half. 

UK
The Brexit deadline has been postponed until the end of October, reducing the probability of a chaotic no-deal exit. If this pushes sterling higher in coming months, the FTSE 100 could suffer due to its large portion of foreign revenues. However, we note that the negative correlation has decreased recently. On a positive note, the market offers a high dividend yield and valuations are attractive. Overall, we stay Neutral. 

Japan
Attractive valuations and improving shareholder returns remain long-term tailwinds, and stabilisation in China could help revive exports. However, EPS growth is expected to be weak in the coming months and the upcoming consumption tax hike may hit domestic activity. Any yen strength could also be a headwind.

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