The Fed’s softened stance comes alongside reports of IMF head Christine Lagarde’s nomination to succeed Mario Draghi as President of the European Central Bank (ECB). Should she be appointed, there is an assumption Ms. Lagarde would resume quantitative easing (QE). Central banks’ dovish pivot is extending the bull market in equities but lower growth will hit company profits eventually and asset managers see the market treading water as an opportunity to build resilience into portfolios. BlackRock’s investment Institute team caution issues such as trade protectionism are “here to stay” thanks to geo-political tensions, especially Sino-American rivalry to lead the new technological age.
So, how do investors position themselves? Increasing allocations to quality government bonds might seem counter-intuitive with rates so low but, with the prospect of rate cuts in the US and negative rates in Europe, capital gains from short duration bonds as yields fall can be reasonably expected to protect portfolios from the worst drawdowns if equities sell off.
Stocks have enjoyed a stellar six months but BlackRock’s Rupert Harrison, head of research for the Diversified Strategies team, says: “Strong performance in H1 means there is reason to be careful (for the rest of 2019)”. Although Mr Harrison advocates a reappraisal of positioning, not exiting the market, he notes that “Historically, late cycle equity returns have been strong”. While acknowledging that quality as measured by profitability is expensive, BlackRock remain overweight US equities – preferring to tilt towards low volatility and momentum stocks that rank below the top echelon of quality.
Tailwinds expected from supportive monetary policy encouraged BlackRock to upgrade their European equities position to ‘neutral’ weight, relative to market cap. This is despite the challenges posed by Brexit, an expected slow-down in growth for the Chinese economy (a major export destination for German manufactured goods) and BlackRock’s own assessment that “European risk assets [are] modestly overpriced versus the macro backdrop”.
Given the difficulty Mario Draghi had in hitting the ECB’s 2 per cent inflation target against a more benign global growth backdrop over the last five years, there is plenty of scope to disagree with BlackRock’s assessment on European equities. After all, they have reduced their model exposure to other regions that will be heavily affected by contraction in Chinese demand. Emerging markets are down-graded from overweight to neutral and Japan and Asia ex-Japan are now underweight positions.
The limitations of monetary policy are likely to be exposed in the years to come and Ms Lagarde is touted for the ECB job partly because her political experience is valued for the task of getting governments to commit to supportive fiscal measures. In this context, reverting to looser monetary policy is an effort to buy time before governments can undertake structural reforms to stimulate growth.
The task is made harder by ongoing trade disputes. Jousting between Presidents Trump and Xi Jinping is unhelpful because, whatever the outcome, it breeds uncertainty. Longer term, Elga Bartsch, BlackRock Investment Institute’s head of macro research, says companies need to realise that supply chains will be disrupted. In the short term, there could be issues of stranded capacity and businesses may have to create contingencies in other geographies. De-globalization may be too strong a term for the changing international dynamic but how companies adapt, especially capex cycles, will tell us a lot about what’s happening in development.
In the meantime, investors are probably sensible to take advantage of market highs to take some profits on holdings with stretched valuations and more cyclically sensitive revenue streams. Holding more cash or shorter duration money market instruments has a cost to it in terms of inflation, but the risk-to-reward trade-off from being overweight shares is looking less attractive, especially once central banks run out of ammunition.
In Alpha:
Of course, this doesn’t mean being out of the market – investors don’t want to miss those late cycle gains – but a circumspect asset allocation, allied to an approach of selecting quality shares at a fair price, is sensible. Phil Oakley outlines some of his views in this week’s shares round-up in Alpha.
Quality income stocks also have defensive characteristics, and the spotlight is on the UK’s income majors (including dividend safety) in this week’s Investors Chronicle lead feature. This week, Alpha subscribers have found from Algy Hall’s rigorous dividend yield screen, that few larger companies with significant pay-outs are valued at an attractive entry point in terms of yield.
At this stage in the cycle, yield is very much a tool for value investors too and two of Simon Thompson’s recent Aim picks (one he still rates as a buy, the other he took profits on) were flagged in Algy’s Aim screen.
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