At our most recent semi-annual Investment Forum, held in Hong Kong in January 2016, we reviewed the key strategic issues present in the global economy and reaffirmed the investment advice we have been offering to our clients, leaving many of our previous strategic conclusions unchanged:
- slow and low economic growth will continue;
- low inflation will persist, but labor markets are tightening;
- monetary policy is not always effective, yet financial repression is still in effect; and
- politics and geopolitics will continue affecting economies and markets.
Understanding these macroeconomic and political issues then allows Allianz Global Investors to calibrate how we, and our clients, should invest. Crucially, we have consistently argued that clients need to take risk in a low-yield environment and that beta returns only will not suffice; the time for alpha has come. Read more in the following summary of our Investment Forum discussions.
Where will growth come from in a world of financial repression?
Sovereign leverage is already high—much higher in developed than emerging markets (EM), though emerging-market debt is rising rapidly. Although this lowers gross domestic product (GDP) growth, additional fiscal stimulus can boost economic activity. Yet with quantitative easing running its course, fiscal stimulus is clearly not a panacea; structural reforms or further currency depreciation may be needed to boost competitiveness.
The growing list of concerns about China overshadowed some brighter news in 2015, centered around the economy’s shift toward consumption, successful supply-side reforms, a growing private sector no longer starved of credit by the big banks and the low valuations of many listed companies. China’s rebalancing will provide global boosts to tourism, entertainment and e-commerce.
With clarity of execution expected soon on the next Five-Year Plan, China’s policy seems to be headed in the right direction: the private sector is being released and resourced, and the state-owned sector is being restructured and reformed by the state-owned banks.
A review of emerging-market debt and currencies
In 2013, we favored emerging-market debt (EMD) and related currencies based not only on attractive break-even spreads, but also on expected higher GDP growth and lower levels of sovereign debt. Since then, EM economies have weakened from collapsing commodities and the re-emergence of over-investment and borrowing in US dollars. Commodity- and non-commodity-based EM economies have clearly diverged, which has benefitted commodity importers considerably. Globally, almost all EM currencies still look attractive, although risks remain elevated.
We expect EMD and oil prices to remain highly correlated – even higher than EMD and US Treasuries were during the “taper tantrum”. Within EMD, we are now experiencing very high levels of spread volatility, and the asset class is suffering from a divergence between sovereign debt itself and that issued by corporates or other entities. On a positive note, EMD trades are now less crowded, with some outflows and less supply expected in 2016. We may see attractive returns if economies stabilize in the second half of 2016 and if the US Federal Reserve (Fed) does not behave unexpectedly.
ESG and climate change
The recent 21st Conference of the Parties (COP21) in Paris sought to reduce greenhouse gases by aiming for net zero emissions soon after 2050, and all COP21 signatories will now adopt and report transparent emission results and targets. With investors around the world responding purposefully to this growing consensus, we expect to see further client action on related issues. Moreover, companies already focused on environment, sustainability and governance (ESG) issues have lower cost of capital, generate higher shareholder value and offer lower volatility. It is clear that in the longer term, ESG will become the industry standard.
Income investing
In the hunt for income globally, the US offers some of the highest yields outside of EM. Importantly, the market structure has been changing because of tougher financial regulation: Investment banks and primary dealers now hold reduced inventories of both investment-grade and high-yield bonds. High-yield bonds in particular have seen a backup in yields as fears have grown over rising US interest rates and rising US energy defaults. Importantly, however, the US has never fallen into a recession without the presence of an inverted yield curve, which suggests that a recession is at least a year away.
It is also important to note that fixed-income investments are not the only source of income potential. Over the very long term, dividend payers in the US have offered both less risk and better returns than non-dividend payers, outperforming 85% of the time. Recently, however, non-dividend payers have substantially outperformed, which seems attributable to both central bank policy and concerns around tax treatment. Yet in a world of financial repression, equity-dividend investing offers stable annual returns with some inflation protection and the prospect of capital appreciation. Moreover, taking a contrarian approach to the momentum-fueled markets can generate good return of capital and income, and offer a defensive way to invest with lower levels of volatility.
Half of all sovereign bonds globally yield less than 1 per cent on a five-year basis, as central banks globally reduce interest rates to the minimum and occasionally below. We hope not to see the US yield curve invert in 2016, as this is a harbinger of recession.
Fixed-income investors do not agree with the Fed’s pace of interest-rate increases in 2016 and beyond, which will continue to cause volatility as sentiment and data shift around. European credit in 2016 will be driven by interest-rate risk and increasingly substantial credit risk. Accordingly, to fund any acceptable return, investors must sail between solid corporates, which offer good yields and volatility levels, balanced with some contingent convertible bonds, with higher yields but much higher volatility.
Inflation, currencies and central banks
While headline inflation is low and has been falling globally, core inflation is actually quite resilient. As oil, commodity and agricultural prices stabilize, we may see a rebound in consumer price index levels during 2016. Inflation expectations remain anchored around 2 per cent, and index-linked bonds look attractive relative to conventional bonds.
With the Fed’s five preconditions for raising rates now met, history suggests the US economy should remain solid for the next year or so. Monetary policy divergence will become more visible in 2016, with the US and UK normalizing while Japan and the euro zone continue to fight disinflation. All other countries will be forced to follow either one policy or the other.
Oil remains a prominent theme as both a harbinger of world economic activity and the epicenter of a serious geopolitical situation. The fall in oil and other commodities has been very deflationary for the world so far, and forced many emerging economies to impose austerity as their finances collapse. Evidence is building of both a drop in future supply and investment, but markets are focused on today’s headlines, which are deteriorating.
Key conclusions
Global growth will remain slow, low and fragile, and inflation will be dominated by oil in the shorter term. Politics will play a key role, as the need for structural reform will only grow, and in the next few years developed economies will continue to outperform emerging ones. Within equities, structural-growth companies will most likely remain attractive in generating capital appreciation, and ESG is now an important driver for many clients. Sovereign bond markets remain unattractive and politics and currencies will affect returns, with yet more volatility added from the difference between the Fed “dots“ and the market futures forecasts. We continue to face investment challenges that are similar to those of the last few years, but with markets elevated, we expect volatility to be high and beta returns to be low. Investors would be well-served to choose ACTive strategies—those that are agile, confident and thorough—at the asset allocation and selection levels.
Mr. Dwane is a portfolio manager, a managing director and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook. Mr. Dwane is a member of AllianzGI’s Equity Investment Management Group and a portfolio manager for AllianzGI European Equity Fund. He has a B.A. from Durham University and is a member of the Institute of Chartered Accountants.
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
A Word About Risk: Investing involves risk. Equities have tended to be volatile and, unlike bonds, do not offer a fixed rate of return. Investments in smaller companies may be more volatile and less liquid than investments in larger companies. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets. Dividend-paying stocks are not guaranteed to continue to pay dividends. High-yield or “junk” bonds have lower credit ratings and involve a greater risk to principal. Bond prices will normally decline as interest rates rise. The impact may be greater with longer duration bonds.
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
Allianz Global Investors Distributors LLC, 1633 Broadway, New York, NY 10019-7585, us.allianzgi.com, 1 800 926 4456.
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