Investor sentiment has swung from an overstated recession scare back in January to a more tempered acceptance of the reality that returns will be constrained by slower growth. Nonetheless, even if market turmoil has made rather too much of the economic risks we face, it has served to highlight that nominal growth is simply too low and valuations too high to expect significant upside in most asset classes.
Considering this backdrop, we at J.P. Morgan Asset Management maintain our view that the economy will continue to grow slowly but positively and that outright recession remains unlikely. Recent worries about a U.S. manufacturing recession strike us more as a consequence of the oil price plunge and the reversal in emerging markets than as an independent source of drag on the global economy.
Our belief in continued uninspiring growth notwithstanding, we are becoming more cautious on asset outcomes because we cannot ignore impaired sentiment, tighter financial conditions and increased tail risks.
Prior monetary policy action from the world’s central banks borrowed returns from the future, but that future is now here. We dispute the idea that policymakers have run out of ammunition. We do acknowledge, however, that loose monetary policy is — at best — a stabilizer, not an accelerant. It will now fall to other factors — notably, fiscal policy, consumption and corporate investment — to generate an incremental growth impulse.
Now is not the time for heroic directional bets. The prevailing environment of muted asset returns demands instead a tone of caution when it comes to asset allocation, which leads us to a preference for low-beta markets and relative-value positions.
We have adopted a broadly neutral stance on stocks versus bonds, preferring to hold equitylike beta through high-yield credit, and have maintained our preference for developed markets — Europe and the U.S. in particular — over emerging markets. We also see duration as an important component of portfolios despite low yields.
Although stocks still look more desirable than bonds on a historical basis, simple valuation metrics miss some of the subtleties behind investor preference in the current market environment. Nominal growth is simply not high enough to drive significant earnings upside in the near term, and the valuation of stocks is too high to look past the lack of earnings growth.
We expect stocks to remain stuck in a broad trading range, likely restricted to the upside by last year’s highs and to the downside by this year’s lows. So whereas we anticipate that developed-markets equities will ultimately deliver positive returns in 2016, those returns are not likely to climb past the mid–single digits in terms of percentages. This calculus is at the heart of our decision to reduce our stock-bond view to neutral, in favor of taking equitylike risk through credit.
With spreads still elevated, a diversified portfolio of extended credit is an attractive substitute for stocks — we see the most upside in U.S. and European high-yield credit. We favor high-yield in part because of prevailing macro conditions. The asset class is stable enough to avoid damage to balance sheets, a tailwind for credit, but insufficiently strong to significantly boost corporate income statements, which can be a headwind for stocks. Another reason high-yield is attractive is because U.S. high-yield credit has overpriced recession risk and is dislocated from equity as a result.
Government bond prices also superficially appear to overstate recession risks. At the same time, however, government bond markets are increasingly dominated by price-insensitive buyers, whose ranks include liability hedgers, regulated buyers and central banks. In addition, increased macro uncertainty makes investors ever more willing to look beyond low, or even negative, yields and maintain a bid for duration.
As was the case at the start of the year, the trajectory of the U.S. dollar remains a key consideration to our asset allocation outcome. There is some scope for a little residual strength, but we see the dollar gradually starting to consolidate, as the market prices in the Federal Reserve’s glacial timeline of hikes. If more stable and uniform global growth aids dollar consolidation, that would signal increased risk appetite and a better outlook for emerging markets. But if the dollar falters because of sputtering U.S. growth, the outlook would darken for risk assets generally.
Ultimately, we remain optimistic about global growth and anticipate a more virtuous end to the dollar cycle, but the risks to this core view reinforce our more cautious allocation stance.
John Bilton is head of global multiasset strategy at J.P. Morgan Asset Management in London.
