Global Investment Opportunity And The Return to Normality

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June 2014

Global Investment Opportunity and the Return to Normality


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It is widely viewed that 2013 marked the end of the period of soft global growth following the global financial crisis, and that global growth should pick up in 2014 and continue doing so for a couple of years. This will eventually return most economies to full capacity, with government deficits also back under control. The return to full capacity represents a return to normality, not a deviation from it. Meanwhile, inflation is likely to stay low, with wage growth only picking up slowly.

But while economic activity begins to appear more normal, the same cannot be said of monetary policy. The key central banks are unlikely to raise interest rates, while the Bank of Japan and the European Central Bank may provide further stimulus. However, with the US Federal Reserve expected to end its quantitative easing (QE) new bond purchases and unemployment falling below 7% in the UK, attention will switch to when interest rates will rise.

Equity markets have been anticipating better economic conditions during the last few years, with price increases caused by rising multiples rather than rising earnings. While multiples still have the potential to expand (especially outside the US), given the backdrop of still-low interest rates, investors will need to see earnings growth pick up in order to push markets higher.

Assuming this happens, profit margins can be expected to remain high, until wage growth eventually starts to eat into profits in a few years’ time. Bond markets have also started to anticipate a return to normality with real and forward yields rising after the QE game plan was announced in May 2013. Yields can be expected to rise further, with no expectation of a bond market crash, nor any reason to assume that bond markets are in a bubble.

Indeed, the performance of most emerging-market economies will be in their own hands. But those economies that fail to improve their efficiency and competitiveness could be challenged by rising US bond yields over the next few years. Those that respond could be rewarded with stronger economies, currencies, and stock markets. On balance, weak sentiment and valuations have set the bar very low, and most countries should be able to outperform these weak expectations over the medium term.

Risk and expectation

The key risk in 2014 is whether markets (bond and equity) will be able to withstand the Fed’s reduction in new bond purchases and the possibility of interest rate increases in 2015. As for other risk-related questions: Will the economic momentum visible now be sustained as the year progresses? Will profit growth pick up enough to meet heightened expectations? Will China reforms happen? Will emerging markets in general cope with a higher yield environment?

Here are some expectations for the days and months ahead:

  • The global economy will strengthen, with companies increasing their spending on labor and capital.

  • Interest rates will remain exceptionally low, but there will be a shift away from easing and inflation will stay low.

  • Equities will perform well, although modestly rising bond yields will put the onus on earnings rather than multiple expansion. Returns will be much lower than seen in 2013.

  • Core bond yields will rise modestly, although peripheral and non-government bonds should do better.

  • Most emerging-market economies and markets will outperform soft expectations, with strong export growth boosting overall growth and profit margins while reducing external imbalances.

  • Key risk will relate to whether bond yields rise only modestly or whether the “end of cheap money” causes more material bond market weakness, undermining all asset classes.

Despite the risks, there are a number of reasons for retaining an optimistic economic outlook. For example, the pace of fiscal contraction across the developed world is likely to ease gradually over the next few years, reducing what has been a material headwind for economic growth. And with inflation remaining stubbornly, if not worryingly, low, monetary policy is likely to remain accommodative for some time to come.

At the same time, banks, consumers, and businesses in the US are generally in good or improving financial health. Indeed, the debt-service cost to cash-flow ratio for US households is at multi-decade lows, according to published research, and high-quality businesses retain high levels of cash. In addition, the shale oil and gas revolution taking place in the US should support growth via lower energy prices. Meanwhile, successful implementation of structural reforms in China (following the Third Plenum) has the potential to continue the transformation of its economy and may eventually lead to a profound re-ordering of the world economy.

Still, the global economy remains fragile and key risks to the burgeoning recovery include:

  • Debt levels across much of the developed world remain extremely high. (It remains to be seen whether a mixture of experimental monetary policy and gradual fiscal contraction can bring about a “beautiful reflationary deleveraging,” as Ray Dalio of the investment firm Bridgewater Associates wrote in his well-known paper, “How the Economic Machine Works,” whereby debt levels are gradually reduced through a benign combination of moderate inflation and growth.)
     
  • The long-term implications of QE and sustained monetary stimulus remain unclear. Inflation has, to date, been confined to asset prices; if an economic recovery does take hold, will inflation expectations prove hard to contain? In addition, will the improving economic environment ultimately result in asset-price bubbles?

  • Can China and other major emerging markets rebalance their economies and implement the necessary structural reforms in the face of rising labor costs and the gradual withdrawal of cheap finance?

  • Instances of geopolitical and social tensions are becoming common. Will societal or regional conflicts have ramifications for global investors in 2014?

These broad themes and risks provide a framework for reviewing portfolios. Having seen very strong returns across a wide range of asset classes in recent years, very few markets now look unambiguously cheap. In such circumstances, there is merit in being patient and adopting a long-term mindset. Investors would be well advised, in addition, to focus on efficiency in portfolio construction and in the harvesting of market returns, as well as on building in robustness to a range of economic and market outcomes.

Specifically, investors should consider the following investment ideas.

Be more dynamic

A high degree of uncertainty remains around the path and potential impact of monetary policy, the growth trajectory of developed and emerging economies, and the direction of markets. While volatility was subdued in 2013, bouts of volatility are likely over the coming years as markets respond to policy changes and economic news. A degree of dynamism is therefore likely to be helpful, both for return enhancement and as a risk management tool.

The potential for economic and market volatility should create the conditions for attractive opportunities in the coming years. And if sentiment remains pro-risk for a sustained period, it seems likely that asset bubbles will emerge. Investors should remain vigilant to these risks and opportunities.

Investors may consider dynamically managing their currency exposure over time. The US dollar is likely to strengthen against most currencies this year, supported by strong economic growth, a further reduction of new bond purchases, and the possibility of the Fed raising interest rates in 2015. Investors should therefore take the opportunity to review their currency-hedging policies and practices accordingly.

Investors should also look to put in place the right governance structure and processes to enable effective decision-making. This might include the use of flexible multi-asset strategies such as multi-strategy hedge funds, multi-asset credit strategies, and diversified growth funds. In addition, trigger-based de-risking and liability-hedging strategies will help liability-driven investors manage risk in a volatile market environment.

Incorporate multiple drivers of return in the growth portfolio

The strong returns achieved across a wide range of asset classes in recent years increase the importance of incorporating a diversifying mix of return drivers in the growth portfolio. Real assets offer the prospects of a diversifying return stream, a premium to reflect their illiquidity, and, in some cases, a degree of inflation sensitivity. Investors should consider real estate, infrastructure, and agriculture/timber assets that offer a long-term income stream and a positive real yield.

In addition, hedge funds can provide investors with access to a range of nontraditional return drivers, including carry momentum, value, illiquidity, deal risk, and complexity risk, among others. Such exposures can be captured either via traditional hedge-fund strategies or via less costly, systematic “alternative risk premia” strategies.

Ensure that equity portfolios are structured to deliver long-term success

As noted, the equity market rally in 2013 was driven largely by multiple expansion; for equity market performance to be sustained in 2014, corporate earnings growth will be required. Mercer expects global earnings growth, which has been weak over recent years, to pick up on the back of the global economic recovery (visit Mercer’s Strategic Themes and Opportunities page).

The gradual withdrawal of monetary stimulus (which is likely to lead to a greater degree of dispersion in company performance), coupled with a less macro-dominated economic environment (with lower correlations between stocks), should be conducive to active management, best achieved through strategies that have a high active share.

Investors should try to capture secular trends in portfolios. This could include tilts to emerging and frontier markets as well as the use of long-horizon thematic growth managers. While many such strategies have struggled in recent years — given the market’s relatively short-term focus on macro developments — long-term thematic growth strategies remain a sensible way to build in some exposure to a range of themes that may have a significant long-term impact on financial assets.

The weak performance of emerging markets over the course of 2013 potentially offers long-term investors an attractive entry point. And alternative indexation (often called “smart beta”) offers low-governance investors a cheap and systematic approach to capturing some well-known “style factors,” such as value, size, and low volatility. Investors need to understand what they are investing in.

Meanwhile, manager monitoring can be improved. A better understanding of the drivers of portfolio performance, more focus on evaluating whether a manager is staying true to its stated philosophy, and an assessment of the costs and benefits of portfolio turnover should contribute to more productive long-term relationships with investment managers.

Build better bond portfolios

From the perspective of defensive portfolios, developed-market government bonds remain set to deliver low, or even negative, real returns. These assets will continue to play an important role in hedging liability relative risk for liability-driven investors, but absolute-return investors should consider the rationale and sizing of any such holdings. As for investment-grade corporate bond allocations, “buy and maintain” approaches offer a more efficient way of harvesting credit beta than index-based strategies (both passive and active) by reducing costs and improving diversification.

From the growth-portfolio perspective, credit markets (from corporate bonds to high-yield and emerging-market debt) have seen significant in-flows in recent years. As a result, prospective returns are relatively uninspiring, perhaps with the exception of emerging-market debt. Multi-asset credit strategies represent an attractive portfolio construction proposition, offering the benefits of rotation across the credit spectrum to reflect prevailing market conditions and duration management (to varying degrees). Notably, one of the few genuinely attractive return opportunities (across all asset classes) remains in the European private debt markets, with opportunities in corporate, real estate, and infrastructure lending.

Build sustainability into the investment framework

A significant body of evidence now suggests that economic agents (at all stages of the investment decision-making chain) have become increasingly short-term in their outlook and behavior. Long-term investors may be able to capture a premium by adopting a longer-term mindset than other investors — both in the way that they interact with their investment managers and in the way they build portfolios.

Part of the answer to building long-term sustainable portfolios will include the consideration of the major long-term risks and opportunities that may have an impact over a multi-decade time horizon. Key mega-trends include climate change/resource scarcity, technological advances, demographic trends, “fair capitalism,” and the emergence of China as a global power, among others.

While it is far from obvious how investment portfolios should be structured to respond to the opportunities and risks that arise from these issues, potential solutions already exist in a number of these areas. For example, private-asset strategies focused on sustainable investment in private equity, infrastructure, timber, and agriculture seek to address the challenges following from the climate-change/resource-scarcity theme. Mercer also believes that benefits will accrue to investors that are able to utilize their ownership rights and harvest an “engagement alpha.” Above all, taking the long view in investment decisions, whenever possible, is as important as it is challenging.

Information contained herein has been obtained from a range of third-party sources. While the information is believed to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential, or incidental damages) for any error, omission, or inaccuracy in the data supplied by any third party.

This does not constitute an offer or a solicitation of an offer to buy or sell securities, commodities, and/or any other financial instruments or products or constitute a solicitation on behalf of any of the investment managers, their affiliates, products, or strategies that Mercer may evaluate or recommend. For the most recent approved ratings of an investment strategy, and a fuller explanation of their meanings, contact your Mercer representative.

Contacts

Rupert Watson (London)
Senior Partner, Investments
+ 44 20 7178 3767
rupert.watson@mercer.com
Terry Dennison (Los Angeles)
Senior Partner, Investments
+1 213 346 2322
terry.dennison@mercer.com
Phil Edwards (Bristol, UK)
Senior Partner, Investments
+44 117 988 7548
phil.edwards@mercer.com
Hendrie Koster (Sydney)
Partner, Investments
+61 2 8864 6306
hendrie.koster@mercer.com

 

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