In his latest quarterly review and outlook, David Riley evaluates the first half of the year and provides his latest views on emerging markets and key risks going forward.
It’s been an eventful first half of 2018, how would you assess the current environment and how have your views developed?
The two key themes at the start of this year were synchronised global growth and the transition to the post-QE era. The first underpinned our pro-risk view and the second, that markets would be more volatile and would favour alternative benchmark-unconstrained investment strategies.
The first half of 2018 has challenged our conviction in global synchronised growth, notably a weaker first half in Europe than expected. The divergence that characterised growth and interest rate expectations between the US and the rest of the world was the catalyst for a surge in the US dollar that exposed the weak links in emerging markets (EM). This divergence theme may persist a little while longer, but we do think that markets have become too pessimistic on the outlook for growth outside of the US.
Recent eurozone business surveys and confidence indicators have stabilised at relatively high levels. Falling unemployment and rising capacity utilisation underpin our expectations for higher consumer and investment spending. Investors are also worried about the risk of a global trade war but the tariffs implemented so far are not big enough to have a meaningful impact on global growth. We expect growth outside of the US to remain above trend and this will be supportive of risk assets, including EM in the second half of 2018.
The transition from quantitative easing to quantitative tightening is being reflected in episodes of elevated market volatility and dispersion in asset performance. Asset correlations and relationships that investors have relied on in the QE-era are breaking down. Traditional core fixed-income offers less safety and diversification in an environment where central banks are moving away from the extraordinary monetary accommodation of the last decade. Greater volatility and dispersion enhances the risk-reward profile of active investment strategies that are global, multi-asset and are either unconstrained or have greater leeway to run a significant tracking error against benchmarks.
You had a favourable view on emerging markets at the start of the year. Has that changed in light of the volatility in recent months?
We still have a positive view on EM assets based on improving fundamentals, valuations and crucially our expectations that growth outside the US will be above trend through the remainder of this year.
The catalyst for the EM sell-off that started in earnest in mid-April was not a surge higher in US interest rates as was the case in the 2013 taper tantrum. But instead, the catalyst was a surge in the US dollar on the back of the apparent divergence between growth in the US and the rest of the world.
Although in aggregate EM fundamentals are better than in 2013 – current account deficits are much smaller; foreign exchange reserves are greater and there are more balanced economies – the sharp move higher in the US dollar exposed the weak links of Argentina and Turkey. Contagion has resulted in a significant re-pricing of EM currencies and credit more broadly. EM policy-makers are responding to the tightening in global US dollar liquidity with interest rate hikes. The market is past critical elections in Turkey and Mexico – although Brazil is still to come. If as we forecast, European and global growth is above trend through the rest of the year, valuations and fundamentals provide a positive backdrop for a recovery in EM assets in the second half.
But we fully acknowledge the extent of the sell-off and that current market bearishness on EM can be self-fulfilling. If investor bearishness toward EM – currently being further fuelled by fears of a global trade war, leads to sustained capital outflows, the tightening in financial conditions will erode EM growth prospects and asset valuations.
In our multi-asset credit strategies, we have cut the over-weight in EM local currency debt but increased our exposure to hard currency emerging market sovereigns.
What are the key risks to your broadly benign outlook for the rest of the year?
Despite a reduction in risk across most of BlueBay’s investment strategies during the second quarter, we remain positioned for markets to perform positively during the second half of the year. There are two related risks to our relatively benign investment outlook for the second half – an escalation of the trade conflict between the US, China and Europe and a slowdown in global growth.
The rhetoric on trade from the White House is uncomfortably vocal and China and the EU are engaging in a tit for tat response. The US has threatened tariffs on a further $200bn of Chinese goods as well as tariffs on autos. A full blown global trade war would be stagflationary – bad for growth but also put upward pressure on inflation, at least in the short-term. In such a scenario, traditional fixed income will offer limited diversification benefits to equity risk in portfolios.
That said, in our view, a meaningful slowdown in global growth and full-blown trade war remains tail risks but the tails have got fatter since the start of the year. For investors, we think this means still having risk on the table – corporate earnings are strong, default rates very low and the break-evens on carry are attractive.
But in the transition to the post-QE era, investors also need to transition from traditional to long-short credit and fixed-income strategies that offer greater scope and potential for positive returns and capital preservation in a more volatile and uncertain world.