After a tremendous run in equities and more than a decade without a U.S. recession, we expect muted, albeit positive forward returns. Our portfolio overweight to equities continues to be fortified by high-grade fixed income.
Global equities continued their climb, considerably outperforming bonds through November and the first half of December. Within U.S. stocks, relative returns across the capitalization spectrum were fairly tight. Growth outperformed value but cyclical stocks gained on defensive sectors, which suggests that value may have room to catch up. EAFE and emerging market equities also have done well during the period. Meanwhile, interest-rate sensitive assets such as REITs and long duration debt have lagged.
Investor sentiment has brightened substantially since August, as most U.S. and global equity indexes currently trade at or near all-time highs. Underpinning the brighter mood are improved economic data and optimism that trade tensions are subsiding, among other things. The consensus view seems to be that the global growth slowdown bottomed in late summer and now is on the mend. Easing global financial conditions have helped foreign manufacturing sectors stabilize. After bottoming in July, the global PMI index has recorded four straight months of gains, auspiciously moving into expansion territory (Figure 1). As manufacturing has picked up so have interest rates; the co-movement between them has been close over the past several years; in this case, higher rates and a steeper yield curve may signify a lessening of investors’ recession concerns.
U.S. growth has been chugging along around trend for months, while non-U.S. growth generally has shown improvement. With the Conservative Party having won a commanding majority in Britain’s Parliament, we expect a diminishing Brexit drag and modest fiscal policy increases to support a gradual advance in European and UK business activity. Importantly, there has been progress on the United States–China trade war, though the peace is still fragile. The recent “Phase One” trade deal reduced U.S. tariffs on $120 billion of Chinese goods and suspended the planned December 15 tariffs on another $160 billion. The deal also contains commitments from China to increase U.S. agricultural purchases and better protect U.S. intellectual property. Despite this development, we do not anticipate a full-fledged retreat of global trade tensions.
Figure 1. Leading financial indicators suggest global economic slowdown has bottomed
Global manufacturing activity is picking up
Source: JP Morgan, Bloomberg, Voya Investment Management, as of 11/30/2019
Figure 2. Sentiment has moved back to neutral
Source: Bloomberg, Voya Investment Management, as of 12/9/19. The Voya Sentiment Indicator is a proprietary aggregate of various sentiment signals.
Figure 3. High quality corporate credit has outperformed low quality despite large stock market gains
Investment grade and high yield corporate bonds, 2019 YTD returns
Source: Bloomberg, Voya Investment Management, as of 11/30/19
Although investors’ penchant for risk has been on the rise, the return dispersion within corporate credit shows a persistent preference for higher quality, lower volatility assets (Figure 3). This reflects a dichotomy in market participants’ mindset: economic fundamentals are improving, yet there remain significant, highly unpredictable risks that could derail the rally at any moment. A similar dichotomy appears in the equity markets, with growth and defensive stocks outperforming value and cyclical stocks. Equity group leadership has been more volatile, however, and not necessarily correlated. In recognition of this unusual price behavior, our portfolio overweight to equities continues to be fortified by high-grade fixed income holdings. Although we have transitioned some of our regional equity allocations to more cyclicallysensitive asset classes, we believe investment grade bonds are a better short- to medium-term bet than high yield.
The majority of the 2019 rise in U.S. equity markets has come from multiple expansion. With near peak profit margins and weak aggregate profit growth, further multiple expansion is the most likely source of future gains. As long as the economic data remain stable the Federal Reserve is unlikely to ease policy in the next few months. Nevertheless, we expect relatively easy financial conditions and a healthy consumer will lead to modest increases in economic growth. In such an environment, we believe U.S. equities have room to move higher. We also see international equities, both developed and emerging markets, which have cheaper valuations and are more leveraged to global growth, as increasingly attractive. We think Europe and the UK should benefit from subsiding Brexit uncertainty, and Japanese stocks could get a boost from new fiscal stimulus through additional public infrastructure spending. With respect to emerging markets, the combination of languishing performance versus the U.S. and our expectations for an uptick in global growth and a softening of U.S. dollar strength will enable EM to deliver decent near-term returns.
After a tremendous run in equities and more than a decade without a U.S. recession, we expect muted, albeit positive forward returns. Our models suggest that the upside for stocks is limited and the outcome tails are fatter on the downside. With our base-case path higher, but asymmetry on the downside, we maintain a cautiously bullish posture. The high quality theme applies to both credits and loans in the fixed income portions of our portfolios. The objective has been to reduce risk in bond portfolios to offset some of the added risk taken in the equity portfolio, where we see more alpha opportunities. Fortunately, the positioning not only has reduced volatility, but also has increased excess returns. With a high demand for yield, a strong technical backdrop and fluctuating sentiment, we could see more momentum and tighter spreads to close out the year.
Past performance does not guarantee future results.
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