In our view, this overly positive sentiment does not reflect underlying fundamentals. Therefore, we did not change our asset allocation and remain underweight in equities and neutral in bonds.
Multiple threats to growth
Our expectations of the global economic development remain bearish, with several threats to continued growth hovering on the horizon. Trade tensions between the United States (US) and China caused severe worldwide uncertainty, and the current cease-fire agreement is by no means a guarantee for a future deal. Chances on a hard Brexit have also substantially increased with the stepping down of Theresa May, as her potential successors Boris Johnson and Jeremy Hunt are both well-known hardliners. On top of that, the recent fight over some top positions in the EU between the different member states symbolized the highly scattered European political landscape. These developments have slowed down growth in the developed economies. Business confidence is sliding, which is leading to stalled capital investments. This will eventually limit employment growth and decelerate private consumption growth. So long as these risks do not fully play out, however, a global economic recession in 2019 remains unlikely.
In response to the reported slowdown of economic growth and the presence of several substantial threats, the major central banks have all hinted at looser monetary policies. The consensus is that the US central bank, the Fed, will cut interest rates at least twice this year, with the first cut already expected in July. Mario Draghi and Mark Carney, the chairmen of the European Central Bank and the Bank of England, also expressed their willingness to provide additional stimulus if necessary. With Japan keeping its policy interest rates below zero and China holding on to its monetary and fiscal stimulus stance, we are moving towards an even looser worldwide monetary policy environment.
This dovish stance led to rallies on global equity markets, as investors counted on central banks to keep the economy running. Bond yields declined, as investors anticipated lower interest rates.
Reality will eventually kick in
In our opinion, however, the current optimism is not backed by underlying fundamentals. Equity markets remain overvalued, as investors have already priced in substantial future easing measures. Yet there is a chance that the implemented policies will not meet expectations. Furthermore, we expect global earnings revisions to remain in negative territory for most global equity markets, based on still elevated earnings expectations and the continuing economic slowdown. At some point, these facts will translate into a shift in perspective and corresponding market corrections. Therefore, we remain tactically cautious on equity and maintain our defensive sector allocation.
We keep our neutral stance on bonds and prefer to be slightly long duration. Government bond yields continued to fall and therefore did not move in line with the optimism shown in the equity markets. Several ten-year government bonds hit new lows in June. The appetite for safe-haven investments shows that at least a part of the bond market is not so overly optimistic about the future of the economy as their equity peers. Materialization of one or more of the many geopolitical risks may take longer yields even lower, especially of the proverbial safe havens. We do not expect the longer government bonds yields to rise significantly in the near term and therefore keep a neutral to slightly long duration position.
The dovish pivot of the central banks also gave credits a boost, driving the corporate bond market in two ways. First, it leads yield-based investors down the credit curve. Second, the increase in liquidity makes defaults less likely. However, the slowing growth makes us increasingly cautious when it comes to credits. We prefer to invest in high-quality names.
Need for a paradigm shift
In the longer term, we feel that another economic downturn is inevitable. As long as the world keeps holding on to the current capitalist system that encourages taking on irresponsible risks, financial crises will continue to arise, mostly harming the poorest part of the population. A recent study that focused on the returns of different asset classes showed that risky investments outperform safe investments by 4-5%. In other words, wealthy people that can afford to take on more risk will earn more than their less fortuned counterparts. Combined with Piketty’s famous theory, which states that the rate of return on capital is greater than the rate of economic growth, this shows that our current system is leading to an unhealthy push towards excessive risks which in turn increases the inequality in the division of wealth. Therefore, the preference for risky investments and short-time horizons over long-term sustainable investments in our view leads to severe disruptions in the social and political environments.
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