The outlook for the US and the world economy has deteriorated, leading us to maintain our defensive stance. However, we think that some risk scenarios currently being priced into markets are exaggerated and hence see select value and the potential for a market rebound. As a result, we maintain our equity exposure, with a focus on quality, diversification and selectivity.
Markets are exaggerating three risks, in our view:
- We do not expect to see a US recession in the coming quarters. The US slowdown warrants a defensive stance, however, we do propose to liquidate the risk assets at current valuations and maintain our small overweight in equities. We cut our exposure to industrials to the benefit of consumer staples and telecoms.
- While credit spreads have widened, we see no significant risk of an imminent credit crisis. As a result, we upgrade US investment grade credit exposure to a small overweight.
- Central banks still have the tools to support the economic outlook. Inflation may remain low, but not for as long as bond markets think. As a result, we prefer inflation-linked government bonds over conventional bonds.
- A tentative stabilisation of oil prices and more clarity around Chinese policy could be helpful to emerging market (EM) assets in coming months. However, we wait to see more evidence of such developments before we add to EM exposure.
- However, we see some value in MXN and RUB, while we have become less negative on BRL. Our upgrade of CAD also suggests that the low oil price has led to too much weakness in some commodity-related currencies.
Exaggerated risks being priced into markets
We agree with equity markets that risks have increased since last month. However, we think markets have gone overboard on pricing them in, and believe it is important not to exaggerate the probabilities of tail risks.
Risk 1: the outlook for the US economy: 2 percent growth, no recession
- US economic data has deteriorated in recent weeks. Data has been weaker than expected, the leading indicator has weakened, and the manufacturing PMI (closely followed by markets) is now weaker than in the Eurozone. GDP for Q4 2015 was weaker than expected as well, driven by an inventory drawdown, weaker-than-expected consumption and weak investment spending.
- Oil prices continue to have a significant impact on US growth. In particular, investment spending in the energy sector is very weak, while it is still growing in other areas (IT, for example). However, the share of the energy sector in investment spending has fallen from around 10% to 5%, and as such we believe, any negative impact should hence be smaller going forward. As for consumption, low oil prices should generally be positive, but US consumers have so far chosen to save the windfall resulting from lower spending at the pump (see graph below). If oil prices remain low, however, consumers may start to see the windfall as permanent and start to spend more.
- We think that the drag from weak investment spending and exports will be offset by resilient domestic demand. The job market continues to expand, and with wages still growing and a healthy housing market, the consumer should keep GDP in a positive territory. Our forecast stands at 2% GDP growth for 2016. Hence, the almost nil earnings growth expected by most analysts seems somewhat low, and talks of ‘recession risk’ seem overdone.
Risk 2: Credit Market Conditions: Credit Spread Volatility But No Credit Crisis
European banks are plagued by negative interest rates that cannot be fully passed on to customers, lower trading volumes, still high non-performing loans and the cost of regulation. European banks’ profits may thus be challenged and we are selective, focusing on first tier banks. That said, we think that recent credit spread widening is not emblematic of an imminent credit crisis.
- Following the credit crisis of 2008, governments decided that even senior bank bond holders should share in the losses of any bail-out, and hence, credit spreads now widen more quickly on any whiff of stress. This argues for a defensive stance in the sector, but, as shown on the graph on the front page, there is currently no indication of stress in the interbank market. The European Central Bank stands ready to provide liquidity, and the European economy has actually been operating without much lending growth. Hence, the risk of credit rationing hurting the Eurozone outlook seems remote.
- It seems wise to remain selective in financials, but we think that the risk of a credit crisis is exaggerated, giving us comfort to add to US investment grade credit, which has become increasingly attractive when compared to US equities.
Risk 3: inflation and negative interest rates:Lower for longer, but not forever.
- Bond markets suggest that central banks have lost the power to steer inflation to their target levels. For the US, current inflation pricing suggests that even five years from now, the outlook for inflation will still only stand at 1.5%, well below the Federal Reserve’s target rate of 2%. The scepticism regarding UK and Eurozone central banks’ power to steer inflation to their target is also very high.
- We believe this fear is exaggerated, and think that there is therefore an opportunity to move out of conventional government bonds (US Treasuries and UK gilts in particular) and can get exposure to future inflation, by buying TIPS and UK index linked bonds at a cheap level now.
- More generally, for market sentiment, the realisation that inflation will not be this low forever would be helpful, as it would also mean that the current policy of negative interest rates should not remain with us for very long; the move to negative interest rates in Japan for example weighed on market sentiment. Core inflation is already rising in most countries, and any stabilisation of oil prices should, with time, also result in slightly higher consumer price inflation (CPI) going forward.
- What next? The world would welcome a stabilisation in oil prices, but there is still no clear indication in this direction, as inventories remain very high. Hence, it is risky and expensive to speculate on higher oil prices, especially given the cost associated to owning oil (a steep forward curve reflects a high cost of storage).
- Our foray into inflation-linked bonds is a cheap way to take a more constructive view on oil, without the cost of the oil price contango, while also staying defensive on credit risk due to the high rating of the issuer.
- Similarly, our upgrade of CAD, MXN and RUB are ways to express a more constructive commodity price view, as we believe that the fall in these currencies more than reflects the move observed in oil. Any clarity on Chinese policy would also help, and the statement by the governor of the Chinese central bank clarifying that CNY will not be devalued to gain competitiveness is helpful in this regard. We also await some more clarity from the 13th 5-year plan in March, but markets may continue to be sceptical on the short term economic data. While we do no see further deterioration in the slow downward trend of the Chinese economy, we wait for further clarity before adding to EM assets.
In summary, we believe that the recent correction has overstated some of the risks and markets can therefore benefit from a bounce in valuations. We therefore maintain our exposure to equity markets. The medium term outlook however is mixed and we maintain a defensive sector exposure, reducing our allocation to industrials. We add to three areas where risks are exaggerated, namely inflation linked bonds, US investment grade credit, and some commodity-related currencies.
Jose A. Rasco is the Chief Investment Strategist for HSBC Private Bank-Americas. He is a member of the Global Private Bank Investment Committee. This column is for informational purposes only. It consists of general market commentary and should not be relied upon as investment advice.