Investment Strategy House Views

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1 The Inflection Point Investment Strategy House Views April 218 For Professional Clients and Institutional Investors only. Not for further distribution. This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination.

2 Contents Overview: The inflection point... 2 The global economy at an inflection point... 3 Market-implied risk premia... 7 Global bonds... 8 Global credits... 9 Global equities... 1 Emerging markets

3 US Treasuries Global Bonds (H) Global ILBs (H) Global IG Credit (H) Global HY Credit (H) USD EM Debt Local EM Debt US Equities Global Equities EM Equities Commodities Gold Overview: The inflection point 217 was a good year for investors with strong returns delivered across a broad range of asset classes and investment strategies (Figure 1). This performance was driven by the Goldilocks economy; growth was not too hot and not too cold but just right. However, we have now reached an inflection point in the economy and markets. Figure 1: Asset classes returns %, USD Total Returns Last 5 years (annualised) YTD Past performance is no guarantee of future results. What is the inflection point in the economy? Global growth trends continue to look strong and synchronized across advanced and emerging economies, but inflation in advanced economies has bottomed and cyclical inflationary pressures are now gradually building, particularly in the US. This combination of above-trend growth and slightly-faster inflation means that monetary policy is set to become less supportive. The balance of risks to the economy has shifted. In the aftermath of the Global Financial Crisis, the primary concern of investors was prolonged weak economic growth and the risk of deflation. But such a secular stagnation scenario is not part of the current distribution of economic outcomes. Instead, today s key economic questions are: (i) how fast can cyclical inflation pick up? And (ii) how will policy makers respond? What is the inflection point in the financial markets? Cyclical inflation pressures have been acknowledged by investors and a market narrative around inflation has emerged. This re-pricing of inflation risk combined with the poor valuation position of global government bonds changes their risk properties in important ways. Investors and regulators typically view global bonds as risk-free or safe-havens. But in an economic regime where the risk is faster-than-expected inflation and where bonds sell-off with market spikes in risk aversion, investors may need alternative sources of safety. We have spent much of the last decade worrying about growth and politics. At this inflection point, tracking the inflation data and policy responses also becomes key for investors. How should investors allocate at the inflection point? For now, the synchronised global growth backdrop and current valuations continue to make the case for equities relative to competing asset classes. Meanwhile, the repricing of inflation risk and poor prospective returns on government bonds support an underweight positioning in developed market fixed income. For multi-asset portfolios, a pro-risk positioning that favours global equities and emerging market asset classes (local debt and equities) continues make sense. 2

4 World US Eurozone Japan UK EM ex China China India Brazil Mexico The global economy at an inflection point Global growth is robust and broad-based; we are in a balanced expansion Economic momentum in developed markets has softened, but emerging markets continue to strengthen Global growth is running at its fastest pace this decade. Our latest estimate of economic activity (Nowcast) stands at about 4.5% annualised (Figure 2) the highest rate since 21. The upswing has become increasingly broad-based across countries with many emerging economies catching-up and supporting a globally-balanced expansion. In advanced economies, growth has remained above trend, although momentum has softened lately. Our Nowcast for the US in the first two months of the year has averaged 3.9% annualised, a little down from 4.4% in Q4. For Japan, there has been a softening to around 1.6% annualised from an average of 2% in late 217. The picture for the eurozone is more interesting; the Nowcast for February dropped to 2.8% annualised, down from 4% in January. This softness was driven by some moderation of survey indicators (PMIs, IFOs), and some surprisingly negative January hard data (e.g. factory orders and industrial production). While we need to remain alert for signs of weaker eurozone growth, for a number of reasons we doubt February s soft patch is a cause for concern: survey indicators remain elevated and consistent with a robust underlying trend in growth; hard data can be volatile early in the year, reflecting weather conditions and changing seasonal patterns; and monetary and fiscal policy remain supportive for growth. Figure 2: Underlying economic activity across DMs and EMs What is a Nowcast? The Nowcast takes a systematic approach to measuring where we are in the economic cycle in real-time. It is not a forecast. Our algorithm builds a measure of growth based on more than 1, key macro-economic variables. % Latest Nowcast Any forecast, projection or target contained in this document is indicative only and is not guaranteed in any way. While growth in advanced economies might be levelling off, emerging economies are providing new momentum to the global expansion. Chinese growth picked up in early 218 and EM ex China has also improved over the last 18 months. Our work reveals that we remain in a synchronised, and low volatility growth phase. It is a balanced expansion, with a very low probability of recession (Figure 3). Figure 3: Fed recession risk model 18 months ago Recession Recession Probability Any forecast, projection or target contained in this document is indicative only and is not guaranteed in any way. 3

5 A big shift towards higher inflation? Inflationary pressures are building in most major economies, especially in the US The sustained period of above-trend growth has led to a change in the market narrative around inflation. For most of the time since 28, the key risk to the economic system and the principal concern for investors has been the possible relapse into recession and the worry of persistent deflation in the advanced economies. However, the situation today has changed significantly. Output gaps have narrowed sharply on the back of robust global growth, oil prices are close to their highest since late 214, and inflation expectations (while still on the low side) are creeping up. The US is arguably further down this path than most other economies. A range of indicators suggest the labour market there is tight, wage growth is slowly beginning to revive, and the fiscal stimulus is set to support further above-trend growth in 218 and 219. Consistent with this, cyclical inflation pressures are building. A broad measure of US inflation (NY Fed underlying inflation gauge) is trending up relatively strongly (Figure 4). Over the coming months, core CPI and core PCE inflation rates are set to rise on the back of base effects versus March-August last year and the recent weakness in the US dollar. The rise in oil prices since mid-217 should give a further boost to headline inflation CPI close to 3% during the year is possible. Figure 4: Inflation is building up yoy % Jan 21 Jan 212 Jan 214 Jan 216 Jan 218 but the movement higher is likely to be gradual NY Fed UIG: Full data measure It is, however, worth making two further points: US CPI Inflation First, despite evidence of cyclical inflationary pressures building, we need to remember that countries are at different points of the cycle. Inflation in Europe and Japan remain below target, and wage dynamics are notably more subdued. Even in the UK, abovetarget inflation is largely due to the weakness in sterling, the impact of which is now beginning to fade. Meanwhile, UK domestic price pressures remain subdued. Second, the structural factors that are commonly thought to have weighed on inflation in recent years such as technology or the globalisation of production chains remain in place. Central banks also remain credible inflation expectations are well behaved. Therefore, although cyclical inflation pressures are building, the movement higher is likely to be gradual. Inflation is a slow-moving and persistent economic variable. 4

6 Cumulative increase in Policy Rate (%) This trend of cyclical inflation has been acknowledged by the market and, as a consequence, a narrative of inflation has now emerged. Our market-implied discounted inflation measure, which is a long/short portfolio of inflation-sensitive assets, is trending upwards, confirming that the market has moved to price-in more inflation (Figure 5). Figure 5: Market-implied Inflation 5% 45% 4% 35% 3% 25% 2% 15% 1% 5% % Dec 214 Jun 215 Dec 215 Jun 216 Dec 216 Jun 217 Dec 217 However, this shift in the perception of inflation risk is principally linked to the pricing out of deflationary concerns, rather than genuine inflation concerns being discounted. The market pricing of a low inflation scenario has collapsed (Figure 5). In other words, what we have seen in market action so far is a shift in the distribution of inflation risks. The key questions for investors now are: how much can cyclical inflation pick up? And what can central bankers do about it? Global policy watch Market-Implied Probability of Low Inflation (<1%) Market-Implied Discounted Inflation While monetary accommodation is being withdrawn, the process is likely to be gradual by historical standards and global monetary policy will remain loose Given robust growth and signs of a cyclical rise in inflation, the pace at which central banks normalise policy becomes a key issue for asset price direction. One part of this is through central bank balance sheet normalisation. The conventional view is that this can have a big impact on markets and is a key risk. In the past, an expanding balance sheet acted as a signal that central banks are committed to easing policy and ensuring market stability. However, we believe that shrinking central bank balance sheets contains no commitment about the future setting of policy. The impact on the real economy and investment markets should be minimal. What s more, the path for balance sheet reduction is already well-known, it will be done gradually, and central bankers have the flexibility to reverse it if needed. Instead, investor focus needs to be on the policy rate outlook and how perceptions of it change. For now, global monetary policy remains accommodative, but the direction of travel is clearly towards incremental tightening. Even so, the interest rate cycle remains slow and low versus historical experience (Figure 6). Figure 6: The current US tightening cycle is gradual versus history Months

7 LOW TO HIGH IMPACT Of the major central banks, only the Fed and BoE are expected to raise rates further this year, and the pace will be gradual. The Fed s forecasts suggest it will raise rates by a further 5-75bp this year, leaving Fed funds in the % range, still low by historical standards. The ECB has become more bullish on the eurozone economy, but it remains cautious on the policy outlook. Indeed, President Draghi stated recently that policy continues to remain reactive and not proactive, implying the need to see evidence that underlying inflation is picking up before tightening policy. On balance, this means that the ECB can surprise the market by keeping rates low for longer. Meanwhile, Bank of Japan Governor Kuroda also signalled a cautious approach, noting that the BoJ could start to consider exit strategies in 219, but only if inflation converges towards target. This is likely to take some time given CPI ex-food and energy inflation is still a little below.5%. Fiscal policy will, on average, be eased during 218. The conditions for continued strong growth remain in place In China, the monetary policy stance is likely to remain neutral this year. However, various measures on the fiscal side, such as the government setting a lower 218 general budget deficit target, means that, in aggregate, policy is set to become somewhat less supportive for growth than last year. Fiscal policy will not be a drag for growth Fiscal policy will also play an important role in the US this year and next. Estimates of the impact of the fiscal loosening on the level of GDP vary but suggest a boost of.4-.8% in 218 and.7-.9% in 219. As a result, despite the gradual tightening on monetary policy, growth this year and next is widely expected to be in the % range. Elsewhere, fiscal policy will not be as supportive, but there is a notable lack of planned fiscal tightening. For the eurozone, budget plans imply a modest easing of policy, but there are differences between countries. Germany s draft fiscal plans, for example, implied an easing of.5% of GDP. What are the risks to the outlook? A key market risk is faster-than-expected inflation. An inflation shock would accelerate central banks tightening path, and, given how asset markets are currently priced, would negatively impact bond and equity returns. We see this scenario as highly probable and one which would have a high impact. It needs monitoring closely. Despite much being written about political risks in 217, they had little impact on market performance. However, this does not mean they can be ignored in 218. Trade tensions between the US and China or, in Europe, the Italian political situation are examples of political uncertainties that have the capacity to shock investment markets. While the probability of a recession is close to zero, a renewal of secular stagnation fears could have a big impact on asset pricing. We put low weight on this risk today. Figure 7: Risk Monitor Renewed secular stagnation Political uncertainty Inflation shock Policy error Productivity boom Market mis-behaviour LOWER TO HIGHER PROBABILITY 6

8 Expected Risk Premia (%, Nominal, USD) Stylised Expected Returns Market-implied risk premia The risk premium framework We have developed a systematic and integrated framework for assessing asset class attractiveness across the entire opportunity set Starting with a scenario for cash rates, we add to each asset class our estimates of the marketimplied reward of bearing specific asset class risk (e.g. risk premium) Emerging Market Equities Alternatives Risk Premium Equity Risk Premium Credit Risk Premium Term Premium Cash Rate This build-up of cash rates plus risk premia produce our measure of expected returns (e.g. asset class valuation) Risk premia change over time, so we need to frequently update our market-implied reward for taking risk Cash Government Bonds High-Grade Credit Spec-Grade Credit Expected Risk Global Equities Emerging Market Equities Source: HSBC Global Asset Management and Bloomberg, as at March 218 Alternatives The pecking order of asset classes The chart below shows the expected risk premium (the excess return over cash) in USD terms for a range of asset classes in our investment universe. These are plotted against adjusted historic data on volatility as a proxy for risk Broadly speaking, asset classes towards the top of the wedge appear to be attractively valued and offer attractive returns relative to their risk. Asset classes towards the bottom indicate unattractive valuations Equity returns and Emerging Market assets are shown in unhedged terms, unless labelled with (H). Developed fixed income asset classes are shown in hedged currency terms Sharpe Ratio Eurozone Equity H Japan Equity H EM Equity Private Equity.2 Sharpe Ratio 4 Local EMD 3 DM Equity US Equity Global REITs.1 Sharpe Ratio Global Credit Global ILBs German Bunds Global HY BB B Hedge Funds US Treasuries Hard Currency EMD Commodities Expected Volatility (%) Global Fixed Income assets are shown hedged to USD. Local EM debt, Equity and Alternatives assets are shown unhedged. Forecasts are an indicative only and not guaranteed in any way. 7

9 (%) Global bonds The risk hedging properties of nominal government bonds look challenged in the current environment. They are not a safe haven asset class After a sharp decline at the beginning of the year, developed market government bonds have recovered some ground. In dollar-hedged terms, their Q1 returns are slightly positive at.6%. However, we still measure a negative term premium for global bonds; the market is penalising us for taking duration risk. Within developed markets bonds, the term premium offered in US Treasuries is the highest, but it still looks relatively low versus history and given where we are in the cycle. Across the curve, shorter-dated bonds offer better risk-adjusted returns. The market re-pricing of inflation risk combined with stretched valuations in government bonds have changed their risk properties. What we saw in February a risk aversion spike causing simultaneous sell-offs in equities and bonds is instructive (Figure 8). It could be that conventional notions of safety are no longer quite right. Figure 8: Asset returns in the largest VIX spikes 1% 5.7% 3.3% 1.3% % -1.5% -1% -9.1% -5.9% -9.2% -2% -16.2% Sep-Oct 8 May-1 Aug-15 Feb-18 Inflation linked bonds and floating rates notes are more attractive in the DM fixed income cross-section US Equity Return US Treasury Return Past performance is no guarantee of future results. So where can investors find safety? A continuation of the cyclical inflation narrative means that inflation-linked bonds (ILBs) look relatively attractive, as do short duration bonds and floating rate instruments. However, these instruments are still slightly unattractive on an outright return basis compared to pre-crisis levels (Figure 9). Ultimately, if the environment is one of rising cyclical inflation, the US dollar should benefit (versus other major currencies). At this point, there are a number of catalysts for dollar strength, including the carry, a possible unwind in dollar pessimism, the growth proceeds of the fiscal stimulus, or a delay to expectations of policy tightening in Europe and Japan. Figure 9: DM ILB yields Dec 25 Dec 27 Dec 29 Dec 211 Dec 213 Dec 215 Dec 217 US UK Japan Canada Eurozone 8

10 Global credits Despite a good economic backdrop, tight spreads means that credit offers little relative to other asset classes Global corporate bonds in investment grade (IG) and high yield (HY) space have been the underperforming asset class year-to-date, exhibiting negative returns in US dollar hedged terms. Spreads have widened around 15-2 bps in global IG and global HY. We continue to hold a bearish view towards corporate bonds. This view is not because we expect fundamentals to worsen. In fact, the economic backdrop is ideal for corporates. As above, a robust growth outlook should mean good corporate profit growth and low default rates. The problem is that the market already discounts much of this good news; today s tight spreads and narrow credit risk premia mean that the margin of safety is thin (Figure 1). Even though the likelihood of a higher interest rate scenario makes floating rate credit assets (like ABS or leveraged loans) more appealing, they still are not offering us attractive risk premia. In our view, multi-asset investors should avoid credit exposure and look elsewhere for better ways to access global growth (such as equities). Figure 1: Current Spreads vs history Spread (basis points) US IG Euro IG US HY Euro HY Asia IG Asia HY Current In line with developed markets credit assets, emerging markets dollar credits have experienced negative returns year-to-date. In Q1 the EMBI+ returned USD -2%, while the CEMBI and Asia Corp less than -1%. This performance, especially compared with the performance of local-currency EM debt, reflect the low risk premia embedded in these asset classes at this point. Although risk premia have increased recently, the tactical investment opportunity in EM credits still looks poor (especially when compared to local-currency EM debt). Figure 11: Credit premia have collapsed Historical high/low Historical average (+/- 1 standard deviation) % Mar 215 Sep 215 Mar 216 Sep 216 Mar 217 Sep 217 % Global HY CRP (LHS) Global ERP (LHS) EM Sovereign Debt USD (LHS) Global IG CRP (RHS) 9

11 (%) Global equities Equities offer the best odds to back the balanced expansion Developed equity markets had a mixed performance in Q The MSCI World fell by 1.2% during Q1 in USD, but this hides significant intra-quarter moves with a fall of 9% during the Q1 selloff. Sector composition continues to play a role in performance across regions, with IT the best performing sector despite a 7% drawdown during the second half of March (Figure 12). Figure 12: MSCI World Q1 sector performance (areas reflect index weights) Telecommunications -5.8% Information Energy -5.2% Technology 3.4% Consumer Staples -5.2% Materials -4.6% Real Estate -3.8% Consumer Discretionary 1.8% Financials -1.8% Health Care -1.1% Industrials -1.6% Utilities -1.5% Our risk premium framework continues to show that global equity markets offer relatively attractive valuations. Popular metrics, such as the Shiller cyclically-adjusted PE incorrectly track equity valuation by failing to account for the prevailing low interest rate regime. We have a preference for late cycle markets such as Japan and Europe The equity risk premium currently stands at a favourable 3.6%. Competing asset classes offer much lower (negative) rewards for risk-taking. Equities provide the best odds to back the thesis of the balanced expansion. An upswing in cyclical inflation should not pose an immediate threat to equity returns either. Wage pressures remain relatively muted and profit margins are wide. There are also signs of an improvement in productivity, which provides an upside risk for global equities. Regionally, we have a preference for late cycle markets such as the eurozone and Japan, versus the US. This is based on relative valuations and relative profits. Figure 13: Trailing 12 month profit margins Dec 25 Dec 27 Dec 29 Dec 211 Dec 213 Dec 215 Dec 217 US Europe ex UK Japan 1

12 Brazil South Africa Russia Turkey Mexico Indonesia India US Japan Germany UK (%) % Emerging markets We retain a preference for emerging over developed markets in both equity and fixed income investments. Even after strong performance, many EM asset classes continue to offer attractive risk premia, both in their own right and versus competing asset classes. We expect EM equity to continue to outperform DM equity due to attractive valuations and improving fundamentals. We prefer Asia ex Japan equities. In addition to attractive valuations, our Nowcast shows that underlying activity in EMs continues to look good with broad-based improvements across countries. This is improving the profits backdrop and supporting FX performance (Figure 14). After a very weak period of earnings growth for EMs over the last five years, we are beginning to see green shoots of profits recovery, led by Brazil and Korea. And a wave of disinflation over the last few years has brought significant policy easing in markets such as Brazil and Russia. Fascinatingly, EMs were are a relative safe haven during the equity market selloff in Q1. This is counter to how many financial market participants perceive EM risk. If the principal risk to the system is faster cyclical inflation in advanced economies, it should still be an attractive point in the cycle for EM asset classes. Regionally, the compensation for bearing equity risk is the most attractive in Asia ex Japan (we measure an equity risk premium of 4.1% versus cash). Figure 14: EM ex China Nowcast and EM FX returns Feb 212 Feb 213 Feb 214 Feb 215 Feb 216 Feb 217 Feb 218 EM ex China Nowcast (LHS) MSCI EM FX Index (RHS) Within fixed income, we have a preference for Latam markets and selective Asian exposure Within fixed income, local currency EM debt continues to offer attractive prospective risk-adjusted returns. A resurgence of growth in emerging markets during the latter half of 217 has continued into 218. As above, this enhances the investment case for equities, but it also supports currency returns for debt investors and bolsters prospective rewards to EM fixed income. Meanwhile, real yields remain high in many EM countries (Figure 15), especially compared to continued low real yields across the DM bond universe. Figure 15: 5 year nominal yields minus expected inflation

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