Negotiating market risks

Diversification is still the key word for investors seeking to mitigate global uncertainty

Global equity markets have clearly started the year on a weak footing. Even after the recent recovery, the global equity benchmark index is still down over 4 per cent year-to-date. There have been many factors at work. However, the rising risk of a US economic recession has taken centre stage.

We still believe we are some way from the end of the business and economic cycle, but the risks of a recession in the next 12 months have increased to around a one-in-three probability.

Then there is the risk of a hard landing in China. Such an outcome would have a major deflationary impact on the world as China would have to ease policy, perhaps even by substantially depreciating its currency.


Light the end of the China tunnel?

China’s economy has clearly continued to slow down despite a significant boost in government spending, bank lending and monetary stimulus over the past year. However, there may be a light at the end of the tunnel – reforms to rebalance the economy towards consumption, and away from investment and exports, have started to deliver results.

Despite this, one of the toughest challenges facing policy makers in Beijing today is the continued capital outflows, which are putting pressure on the yuan, forcing authorities to spend foreign exchange reserves to stabilise the currency.

China’s foreign exchange reserves fell USD700 billion last year, to USD3.3 trillion. This is still an impressive stash, but only as long as the current pace of capital outflows is stemmed. This is why we expect the authorities to tighten capital controls further.


Getting back to pre-recession norms

Piecemeal efforts such as these are being implemented across several economies to restore growth and ward off deflationary pressures. This is notable in Japan and Europe where central banks have cut some benchmark interest rates to negative.

However, investors have started to question the effectiveness of such policies, given that years of easy money policies across the developed economies have failed to lift growth and inflation back to pre-recession norms.

Given the rising risks, we believe a coordinated and credible global policy response from an international platform such as the G7 or G20 would be positive, especially for equity markets. So far, there are few signs of this.


Shielding investments from rising risks

What does this mean for investors? On balance, we still expect positive equity market returns with modest earnings growth this year, especially in the euro area and Japan. However, uncertainty has increased, especially with equities appearing to have discounted a recession less than many other asset classes.

A time-tested way to shield investments from rising risks is a diversified basket of assets, in our view. We believe in focusing more on lower volatility, relative strategies. Our strongest conviction is in alternative strategies, some of which are driven by macro themes, or which take a non-directional view on markets through equity long-short strategies.

High quality bonds also offer a safe-haven in this environment. Within this space, we have a preference for US corporate bonds. US high yield bonds are factoring in extreme pessimism – they are expected to generate positive returns despite an increase in corporate defaults. Meanwhile, US investment grade bonds appear to be pricing in a recession (which we believe is unlikely in the next 12 months), which makes valuations attractive, in our opinion.

In these uncertain times, the other factors to watch are the US dollar strength and Chinese yuan weakness. These are seen as being negative for risk assets. A change in these trends would likely be positive, especially for emerging economies, which have borne the brunt of the market downturn in recent years.


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