Readers not au fait with Disney’s The Lion King, may be unaware of the song 'Hakuna matata'. The title is Swahili, roughly translating as “no worries”, and the choice by Barclays’ research team to borrow it for their summer 2017 report is a nod to the remarkably low volatility witnessed in financial markets this year.
Leading research teams are now publishing mid-year revisions to their global economic and investment outlooks. Reviewing Barclays’ team’s analysis alongside that of their counterparts at Morgan Stanley, the picture that emerges is of a bullish stance for risk assets for the rest of 2017. Of course, these institutions have a vested interest (as we all do) in the continuation of investors’ recent positivity but, as the remarkably low level of the VIX (Wall Street’s 'fear index') shows, many participants are sanguine about the risks that always underlie financial markets.
A benign macroeconomic backdrop for equities
Low volatility does not mean low risk. Realised volatility has not been high because, thanks to benign macroeconomic conditions, there haven’t been triggers for risks to materialise. Implied volatility indices (like the VIX) do not measure risk at all; they isolate the rate of change in options pricing which highlights the fear of risks. Barclays argues that we have been in a sweet spot for risky assets such as equities, hence the mellow market sentiment.
In Barclays’ view, there isn’t some dangerous market complexity afoot keeping volatility down. It is confident that the synchronised global economic recovery remains on track and, although core inflation in some key economies such as the US and Japan has started to come off a little, falling unemployment should assuage fears of deflation. Barclays actually interprets the slowing inflation positively – as motivation for central banks to refrain from tightening monetary policy too quickly. Morgan Stanley has a similar view and expects a continuation of easy monetary policy and low volatility to drive more risk-taking from investors and induce company chief executives to embark on growth-boosting capex projects.
Optimism has been raised by the first synchronised global recovery since 2010
The chart shows how emerging markets and the US are once more growing concurrently.
Global valuations not ready to come off just yet
Morgan Stanley acknowledges that while better growth and monetary policy are supportive factors for equities, in some markets, valuation levels do pose cause for concern. They do not, however, anticipate an imminent correction. Although valuations are effective at predicting annualised returns for a wide range of assets on a timescale of five years and upwards, they are a poor predictor of short-term performance. It is common for valuations to overshoot late in cycles and, in any case, not all regions are especially expensive.
The high price/earnings (PE) multiples at which indices such as the FTSE 100 – and especially the S&P 500 – are trading worry investors, but there are still stock markets that look more reasonable. In other asset classes, both teams are more cautious on corporate bonds – especially high-yield US corporate debt – and overall, Barclays and Morgan Stanley would both tilt their portfolio allocations more towards stocks than fixed-income investments.
Asset allocation not market timing
A key point to note is that neither bank uses its research to time when to be in or out of the market entirely. Both houses make decisions on whether to have ‘overweight’ (OW) or ‘underweight’ (UW) allocations towards different assets and regions. Tactical calls are made on the investments they believe will outperform in the short to medium term, while risk is spread within the framework of a diversified long-term investment strategy.
Current tactical tilts
At the asset level, both banks’ research teams prefer equities to fixed-income investments. Given the backdrop of an earnings resurgence, tighter spreads in advanced economy bond markets and the possibility of US tax cuts, Barclays’ view is that stocks still have a more attractive risk-reward profile than bonds. Likewise, Morgan Stanley believes equities “are supported by strong earnings growth and rising animal spirits”.
Within equities, the two teams differ over preferred regions. For Barclays, there is most upside to be had in the eurozone and it is also very positive towards Japanese stocks. Morgan Stanley shares the enthusiasm for Japan, but in a markedly different call have upgraded their forecast for the US.
Morgan Stanley displays its weightings in a simple grid with five settings from negative to positive, and has just upgraded US equities from its middle setting (neutral) to its fourth setting (slight overweight). European equities remain at neutral and Japanese equities are downgraded slightly from strong overweight to slight overweight. Emerging markets are upgraded from the lowest setting (strong underweight) to slight underweight.
As mentioned, these positions are tactical tilts from the benchmark exposure for institutional investors. The Morgan Stanley benchmark is a 50 per cent weighting towards equities, half of which is in the US market; a fifth each is in European and emerging market shares; and a tenth is in Japanese shares.
Overall, the current Morgan Stanley tactical asset allocation sees it move to a 55 per cent equities holding, with 26 per cent in government bonds, 14 per cent in corporate bonds, 2 per cent in commodities and 3 per cent in cash.
Barclays shows its equity allocations as percentage movements from the MSCI World index. The MSCI is a market capitalisation weighted index, so there is proportionately a higher weighting towards bigger equity markets to begin with. This means that, again, over half of equity exposure is towards the US.
Therefore, when Barclays says it is “neutral” towards the US it still has over 50 per cent of its equity allocation towards the world’s largest market. Its overweight position towards Europe (excluding the UK) consists of a two-and-a-half per cent heavier weighting in the region than the MSCI World (17.7 per cent versus 15.2 per cent). Barclays is OW Japan by 2 per cent (9.7 per cent versus 7.7 per cent) and UW the UK by 1.5 per cent (4.3 per cent versus 5.8 per cent), and UW emerging markets by the same amount.
Looking across all asset classes, Morgan Stanley currently has 41 per cent specific regional exposure to the US, 20 per cent to Europe, 10 per cent to Japan and 21 per cent to emerging markets. The rest is made up of securitised credit, cash and commodities. This helps put the research into context and demonstrates that portfolio adjustments are subtle: they involve positioning for macro themes at usual rebalancing intervals. Sensible portfolio management is not about chasing returns; instead it is about managing risk and not deviating from an acceptable level of potential downside in case your macro calls are wrong or miss-timed.
Momentum has peaked, but the global recovery is intact and equities should benefit
Barclays’ case for remaining OW equities is in part because the global recovery remains broadly intact, even though growth momentum is forecast to decelerate in the second half of 2017. Europe has surprised pleasantly on the upside, but the US growth outlook is considered to be shrouded in uncertainty and the report notes the gradual slowdown in China.
The effects of oil price recovery on inflation in the latter part of 2016 have started to fade and muted wage growth has kept core consumer prices indices (CPIs) low. This, as mentioned, is seen broadly favourably, with the European Central Bank (ECB) and Bank of Japan remaining cautious, although the Barclays report highlights the risk of inflation and growth disappointing.
Political risk, so prominent in 2016, has taken something of a back seat this year. Eurocrats and internationalists breathed a sigh of relief with the Dutch and French elections apparently stemming the tide of populism. In addition, much of the protectionist rhetoric that was such a feature of Donald Trump’s election campaign seems to have been watered down now he is president. For the rest of this year, Barclays flags potential divisions in the US Congress over tax reform and government debt funding, the divisions in the UK over Brexit and China’s Party Congress in the autumn as the main political headwinds.
For the rest of 2017, the reports focus more on the rate and sustainability of growth, with Morgan Stanley stating that “the essential debate in today’s markets is whether the first or second derivative of GDP matters more”. The bearish argument is that the level of growth (the first derivative) might be fine, but its rate of change (second derivative) is set to worsen, something that has signalled good selling opportunities over the past six years.
Morgan Stanley counts itself on the bullish side of the market, arguing that the level of growth will be more important than the rate. On this point it is optimistic, with the breadth of global growth raising hopes of a synchronised recovery. It summarises its view thus: “If the breadth of growth is better, and nominal GDP is higher, we think that sensitivity is reduced, and markets can weather a weakening ‘second derivative’.”
Growth in capex is good news for an economic recovery previously dependent on consumption
Although the Barclays report says that momentum has peaked, it does not believe a modest deceleration in the second half of 2017 is threatening the overall picture and that, over the full year, there will be a firm uptick in annual growth compared with previous years. Global business confidence measures signal a continued expansion in industrial activity and Barclays feels that accommodative policies and financial conditions remain supportive, raising the possibility of a more sustainable global recovery, powered by business investment and not consumption alone. On this basis, it forecasts annual growth of 3.8 per cent in 2017, 0.5 per cent higher than 2016, and expects this pace to be maintained into 2018.
Finding value in equity markets
The investing style Barclays advocates for the US is value over growth, but the caveat is that this positioning is very much in anticipation of corporate tax cuts and it sees little upside priced from a relative stock perspective.
In Europe, Barclays favours value over low volatility or quality equity investing. European banks are highlighted as near the cheapest they have been relative to US counterparts since 1980. In emerging markets the opportunity highlighted is buying relative value, in particular in emerging Europe, and reduction in exposure to cyclical commodity risks.
Morgan Stanley has a more bullish stance on the US than the consensus opinion. Barclays and others would point out that Europe is very cheap relative to the US, but Morgan Stanley counters that, saying that while this is true on a normalised PE basis, the divergence in value between the US and Europe is no longer especially large on other metrics. Morgan Stanley flags the fact that sector-neutral relative 12-month forward PE for Europe versus the US has now risen above its long-run average. Also, the renewed strength of the euro is seen as favouring US equities.
Furthermore, Europe’s relative performance versus the US recently hit 2.9 standard deviations (SD) above its 12-month average, the highest level since November 2008. Since the 1970s, levels above 2.5 SD have often coincided with tactical peaks in Europe versus US equities. Also, Europe’s relative earnings revisions ratio versus the US has rolled over. Again, recent EURUSD strength is a factor and Morgan Stanley argues that this points to further weakness in relative earnings revisions momentum.
The risk/reward outlook for equities
While unflustered about the implications of low volatility so far in 2017, Barclays points out that many of the drivers of the low volatility regime are reaching their limits. Its expectation is that any US data surprises will be negative, as corporate sentiment surveys have fallen from their peak. Chinese sequential growth is also likely to slow in the second half of the year, albeit remaining relatively stable. Commodities and inflation are falling back, with the oil price again looking weak. Add to this the Fed’s tightening of US monetary policy, rising equity valuations and elevated active manager positioning - with short interest at low levels - then scope exists for volatility to return in a meaningful way.
Morgan Stanley also doesn’t expect the market tranquillity to last into 2018. It expects central bank policy to become much less accommodative, with increased Fed hiking, the ECB tapering and the Bank of Japan exiting its yield curve control strategy. Also, if its assumptions on growth are right for the rest of 2017, asset prices will be even more expensive by the turn of the year. For now, though, investors should relax and enjoy the calm.
