The boring approach is best

By Jayson Forrest - Managing Editor  - IMAP Perspectives

With continuing concern on the economic impact that may be caused by the COVID-19 virus, Michael Karagianis believes it’s best to take a conservative approach to investing during these times of heightened risk.

<Body>The past year proved to be an interesting period, where surging asset class returns were seemingly divorced from deteriorating economic momentum and rising geopolitical risks. Asset classes from Australian and global shares to bond markets turned in one of the strongest years of correlated returns since the Global Financial Crisis.

A major supportive factor ‘trumping’ the poor macro backdrop was the willingness of central banks around the world to underwrite market performance by progressively cutting interest rates and, in some cases, re-introducing quantitative easing. Markets reacted strongly, as shown  in Chart 1.

Looking forward, the outlook is less clear cut. Economic data across major regions remains mixed and subdued, although on balance, shows early signs of improvement. 

Forward-looking indicators, including Purchasing Managers Indices (PMI) surveys around the world, have stabilised over recent months and point to a pause in the manufacturing slowdown. However, these ‘green shoots’ could be severely, even if only temporarily, derailed by the impact of the COVID-19 (coronavirus) on global trade, manufacturing and growth.

Easier financial conditions in 2019 - lower interest rates, higher asset prices and more liquidity - typically would be expected to improve growth, with lags on a six to 12-month horizon. This should provide near term support to a global recovery in 2020. 

In addition, some of the threats to the economic growth and corporate earnings outlooks have seemingly receded with the ‘Phase 1’ US/China trade agreement and the decisive UK election result.

Chart 2 shows the weakness in earnings over 2019 and consensus expectations for recovery in 2020

Although 2020 estimates look typically overly optimistic, as is normal early in a year, the fundamental case for a more positive earnings outlook compared to 2019 is reasonable, given the slowdown in economic growth over 2018 and 2019 appears to be at least stabilising.

As always, investment strategy needs to balance an assessment of shorter-term influences on fundamentals and market pricing against those more likely to shape investment returns over the medium to longer term.

Over the long-term, lower potential growth rates (due to the headwinds of demographics and low productivity growth), high debt levels, a mature global expansion and monetary policy settings at close to ‘full throttle’, leaves little room for a sustained upside surprise to growth.

In addition, recent developments do little to limit threats to the longer-term growth outlook posed by US/China relations, European disunity, populist politics and de-globalisation pressures. The long duration and unpredictability of the forces underlying these themes makes them difficult to measure and price, although their influence on markets over recent years is clear.

Major global shifts in areas such as trade and policy also have the potential to reshape the longer-term growth and inflation outlooks, and so represent a source of uncertainty for markets.

In the near term, with the usual monetary tightening cycle that usually ends expansions reversed in 2019, the current expansion looks likely to be sustained, albeit with limited upside potential. From today’s highly priced starting point, the medium to longer term outlook for risk asset returns is a world of ‘low numbers’.

The challenge for all investors is reconciling the unique characteristics of today’s economic and policy backdrop with their previous historical experience. For example, the normalisation of interest rates has been persistently over-anticipated, while the lower bound of negative nominal rates has been underestimated by both markets and central banks in the post-GFC decade. These examples are reminders of the need to be humble in forming decisive expectations for the outlook and in positioning portfolios.

Valuation is the most influential driver of longer term risk asset returns and an increasingly important risk indicator, given the late stage of the post-GFC expansion.

Longer term, investors in equities are paying high equity multiples today for a low growth outlook, which faces into a unique set of longer term disruptive threats.

• Of specific concern in the near term is the potential risk of COVID-19, where the economic impact over the short-term could be significant, although previous experience suggests that the global and regional economic impacts could be offset by a rebound later in 2020.
  In our view, Australia as an economy is relatively exposed to a more significant and longer term slowdown in the Chinese economy.
  
  In addition, a number of the key sectors of the market appear likely to be constrained in their future earnings growth potential. As a consequence, a prudent strategy would be to maintain or adopt a more defensive growth asset exposure, primarily through an underweighting to Australian equities.
  
  Other strategies we believe are worthwhile to consider in this uncertain environment include:
  An overweight to foreign exchange versus the Australian dollar. The initial sell off in the Australian dollar would be expected to continue if the COVID-19 emergency proved more dramatic and longer lasting in its economic impacts.
  
  Equity portfolios that are overweight travel/tourism-related stocks are most exposed in the short-term. However, the longer the situation goes on, the larger and the more widespread the impact flowing through to all Australian companies exporting to China (mining, education, agriculture and so forth).
  
  Gold could be a worthwhile risk diversifier within portfolios, given its tendency to outperform in severe ‘risk off’ situations.
  
  If COVID-19 plays out like SARS, allocating large exposure to traditional defensive assets could be costly. For that reason, longer duration bonds, whilst likely to benefit in a risk averse environment, are not a preferred investment for us, given the particularly low interest rates at present.
  
  Given current market valuations, especially in particular sectors, and the improving economic outlook (the impact of COVID-19 notwithstanding), we hold a strong preference for active management.
  
  

However, overall, we believe that a broadly diversified portfolio construction that ensures portfolios are not overly reliant on a specific future economic and policy scenario, provides the best overall defence against uncertainty, a further downturn in the current business cycle and/or the potential for longer term shifts in growth, inflation and interest rate outlooks. 

It may seem boring but it’s the best approach to balancing the potential risks against likely anaemic asset class returns.

Michael Karagianis is Senior Consultant, Retail Partnerships, JANA.