Lacklustre growth can still offer opportunities

High levels of correlation within risky assets has meant that navigating the environment has been difficult. Market concerns in January and February centred around three key macro issues.

First, market participants became increasingly concerned about a manufacturing-led US recession. Second, there was a reflexive tendency among investors to infer a growth signal from weak financial prices in other asset classes (the falling oil price, plummeting bond yields, weak shipping indices). Third, there was heightened uncertainty around the outlook for China and especially the policy agenda.

Yet since the equity market lows in February, risky asset classes have roared back strongly through March. Market pricing has dramatically moved on from embedding recession risks in February, to now discounting an improved economic picture.

What drove this volte face?

Partly, the expectations of weaker growth were not well calibrated assessments of the future. But, also, it was policy; aggressive easing measures from the Bank of Japan and ECB, as well as a clarification on China’s currency policy and a renewed emphasis on fiscal support following the G20 summit.

The Fed did their bit too, by passing on the option to raise rates in early March and providing very dovish forward guidance.

So how should we understand all of this?

Most importantly, it reinforces the view that there is a huge amount of noise in financial markets. More often than not, market volatility is an excessively sensitive reaction to adverse news-flow. As such, making sense of the market environment requires a discipline around valuations and a clear, structured analysis of economic risks.

Growth risks, even phantom recessions, can create substantially volatility in financial markets, as we have seen in Q1 Joseph Little, HSBC Global Asset Management

In the early part of this year market pricing was beginning to reflect the notion that there would be a meaningful shortfall of aggregate demand relative to supply, and that nominal growth would be so weak that corporate fundamentals would be undermined.

But despite the suggestion of many analysts that central bankers were “out of ammunition”, policymakers were able to provide a cushion.

So where does this leave us today?

We are in a “fragile equilibrium”. The global macro environment remains one of lacklustre growth, but there is no inflation psychology. In fact, despite the market turmoil, the cyclical outlook remains broadly unchanged, though growth expectations have been revised down somewhat.

However, economic momentum has actually improved a little in the US and in emerging markets. Oil prices have stabilised, and deflation fears have receded. Significantly, however, an important result of the recent market turmoil, and a recurring feature of this cycle, is that the market’s assumption of “lower for longer” interest rates has now become one of “lower for even longer”.

The good news is that risk asset classes are in an equilibrium of sorts. The market odds have compressed materially since the February lows, but long horizon investors are still being paid to take equity risk.

Yet from here, the reality is that overall total returns are set to be low – in the order of 5-6 per cent before inflation for global equities, rather than the 6+ per cent after inflation we have gotten used to in the past. But at least equities offer a decent carry versus safety asset classes.

The problem, however, is that the economic environment remains challenging and perceptions of risk are febrile. Growth risks, even phantom recessions, can create substantially volatility in financial markets, as we have seen in Q1 – even if these worries are later revealed to be noise. Low sustainable returns and bouts of episodic volatility are a challenging mix for investors.

That said, the broad environment remains reasonably supportive for equities, especially outside of the US. The global growth outlook is lacklustre, but there is no recession. Moreover, the spill-over from the sectoral recession in energy has been limited so far.

The outlook for so-called safety assets looks more dangerous however. Indeed, there are no safety assets.

Core bond yields are incredibly low versus history. Of course, government bonds are the natural beneficiaries of negative interest rates. But it is a concern that just as a significant amount of bond-bullish news is reflected in today’s pricing, the structure of US inflation is beginning to rise. It could be much better to focus on lower duration plays, including High Yield credit.

Emerging market bonds have fared strongly year-to-date. A reminder that the definition of safety asset in today’s environment must be flexible. It makes sense to nuance enthusiasm for the asset class after rapid strong performance, but allocating to local EM debt can still make sense for long-term investors. Prospective returns continue to look relatively strong, many EM currencies remain unloved, and an active, selective approach should add value.

The market environment has moved quickly from fearing a “secular stagnation” in January and February to discounting lacklustre growth in March. What happens next? Who knows.

But, given the backdrop, it wouldn’t really be a surprise if perceptions of a “stronger recovery” began to emerge, especially in the US.

Joseph Little is chief strategist at HSBC Global Asset Management