As the global economy heads for a structural and cyclical slowdown, the appeal of fixed income and, in some instances, credit is evident. We see value in the periphery of Europe, European credit (including the ultra-safe covered bonds) and some financial debt. Beyond this, the outlook for equities after two quarters or a mild earnings recession is weak growth ahead. This translates into somewhat subdued equity returns, while central bank easing should limit the downside and eventually help the upside. In such an environment or sideways markets, we continue to prefer portfolio and defensive equities, such as listed real estate and infrastructure as part of a wider mix. Absolute return strategies continue to help improve the risk return profile, although not all are equal.
The clash of titans
The trade negotiations between the United States and China have tasks a difficult turn as China backed earlier promises leaving the US president looking weak in the eyes of hardline Republicans, a group considering his voting base. The process of escalation and now the escalation should take a few weeks. With low growth in the United States and China, we see very decent odds that both the presidential head towards a middling trade deal in Q2 or Q3 2020, just in time to have an impact on the US presidential elections. That said, there is still a possibility that the situation will be far worse as either president may want to burn his credentials as a hard negotiator. This would happen in Q1, far enough away from the election for the shock to growth and equities to dissipate. The deal would probably be focused primarily on agriculture and manufacturing. Gyrations in equity markets around this theme should continue for months to come, with Emerging Markets moving the most and offering opportunities, as we expect an eventual middling settlement. Yet, the opportunity is more in fixed income than in equities.
Japanification - opportunity in fixed income
The global economy is slowing down both structurally and cyclically. There are three causes - the first is structural. Secondly, populations are aging across the board from Japan, to Finland, Italy, Germany and more - a shock that increases savings or conversely depressed consumption. The third factor is technology, which is quite complex. The search for yield not only forces companies in mature sectors to cut costs, which depresses demand, but also to innovate. Furthermore, low interest rates make it far easier to bring companies to the market. That means that the pace of technological progress is likely to indicate greater than our current measurements, and the outcome is low inflation. For example, a new entrant into Norway's retail market, such as Lidl, with its far more cost-efficient model, could sharply depress an extremely elevated price structure. At the same time, Lidl collapsed in Norway having failed in its mix of product, strategy and packaging. Innovation is not a one-way process.
Cyclically, the global economy is slowing down, driven by a balance sheet crisis in China and, to a lesser extent, the Eurozone. There is too much capacity in China and not enough sound balance sheets among financials. Hence, the Chinese government has intervened to delay the eventual compression in capacity and to ease financing conditions, although keeping them relatively tight in the overly hot real estate sector. Chinese data may be questionable - indeed growth is likely around 4.2 percent and heading for 3.7 percent on the back of the trade - but the authorities are very credible. They will eventually turn the boat around. This shock to growth is hitting Europe, especially Germany, and is impacting the US as well.
The combination of a structural and cyclical slowdown, and in some cases balance sheet issues, eg China, means that the mix of growth and inflation is weak: a perfect recipe for fixed income solutions (and to some extent credit). The European periphery, such as Italy and Greece, are obvious choices in the fixed income space. The choice in credit is more complex.
Prefer defensive equities
In a world where expected growth is weak, as is the eventual recovery in earnings, the outlook for equities at least in developed markets is subdued. In such a market with potential sideways equities, investors should focus on equities that deliver some return while giving safety, namely by delivering stable cash flows. These can be found in a few products, but primarily in listed real estate and infrastructure which show limited drawdowns relative to broader indices and perform decently. More broadly, we continue to emphasize resilient portfolios - those that are well diversified and sometimes include absolute return performance (although not all are equal).
European Fixed Income - Love Italy
The political situation in Italy is a difficult one with a left-wing coalition that could be unraveled in a year's time, yet neither the extreme left nor right wants to leave the Eurozone and they are largely abide by the Eurozone framework. That leaves the problem or underlying credit risk. The Italian economy grows far too slowly relative to its rising debt level making the debt dynamics unsustainable. Yet, Italians save a lot, as can be seen by their 2.6% current account to GDP ratio, and so does the Eurozone as a whole. A significant part of this will go into fixed income wherever yield and safety can be found. Add the backing of the ECB and what you have is a large carry trade in the Italian sovereign curve or BTPs. There are other ways to express this preference, such as covered bonds and Italian credit. Over time, as the sovereign curve flattens more, the economy will eventually recover and credit risk will fall, helping financials and their debt and supporting Italy. Such positions can be tasks outright or as part of wider funds.
Prefer European to US creditConclusion: Japanification and sideways equities
The outlook for Credit is appealing in Europe, more so than in the US. The current economic slowdown suggests the balance sheet analysis of active managers. In Europe, credit risk premiums are roughly in line with historical averages while leverage is generally not excessive as it can be in parts of US High Yield. But discrimination is important in Europe (e.g. CLOs). Some companies are heavily exposed to the economic slowdown. EM shocks and the rapid pace of technological transformation will cause some defensive stocks to succeed while others fade away. This reality is far more acute in the Eurozone where growth is weak and set to stay that way than in the United States. Take for example Deutsche Bank. It is rapidly shrinking its balance sheet, some of its activities and personnel and hopes that a lower IT budget will be enough to cover waning business demands. The race for IT and transformation will only be won by some companies, namely those that latch onto the right growth sector. UBS for example has a dominant position in the Wealth Management business and runs it very well, yet the returns are not what they could be, given the phase in this sector. In the US, the outlook is more mixed with investment grade expensive but appealing as the Federal Reserve eases and the lowest tranches of High Yield deleverages. High Yield may still be appealing but with prudence as fears of a recession could return to hit this overly leveraged sector hard.
Conclusion: Japanification and sideways equities
In conclusion, we see continued opportunities in fixed income and, in some cases, credit, particularly in the Eurozone amid a Japanification theme. Given an economic slowdown, we prefer the balance sheet analysis or active credit risk managers. In equities, potential sideways equities suggest more defensive funds such as listed equities and infrastructures.
Note: This is a NAM macro view, not the official Nordea view.
