Playing defensive: Time to hedge against rising uncertainty
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MARCH marked seven years of the US bull market. If the S&P500 Index has held up until yesterday, investors will celebrate the second-longest bull run in US history. This raises the question: Is this bull run getting too long in the tooth? And, if so, how
The first question is always difficult to answer with any degree of certainty. This became apparent in the first quarter when US stocks plunged more than 10 per cent from the start of the year until mid-February, only to bounce back and recoup the losses by April.
The factors behind the sell-off – concerns about slowing growth in the United States and China, falling commodity prices and worries about a sharp devaluation of the Chinese currency – also led to the rebound as those concerns eased, helped in no small measure by increasingly accommodative central banks.
However, one should not be lulled into a sense of complacency by the recovery in riskier assets, which included a vigorous rebound in commodities, emerging-market stocks and higher-yielding bonds from oversold levels.
The latest rally masks an increasingly uncertain outlook for global growth and earnings, so it offers an opportunity partially to rebalance out of equities into more defensive assets such as bonds and alternative strategies that are less likely to move in tandem with equity markets.
US expansion continues
The US economic expansion since the 2008-09 financial crisis is already the fourth-longest in the past century. So history is not on our side.
Economic expansions are typically longer after a major downturn as providers of goods and services cater to pent-up demand.
The US economy has been recovering from the longest and deepest recession since the Great Depression, as demand for housing, automobiles and other consumer durables are met.
With borrowing costs near record lows, inflation still subdued and central banks worldwide staying highly accommodative, the US economy continues to generate jobs at a steady pace, keeping the consumer-driven economy humming for a while longer.
The recent weakness in the US dollar and recovery in oil prices also reduce the drag on the US export and energy sectors.
China’s economy appears to be stabilising – note the nascent recovery in manufacturing and services-business confidence, strong pick-up in the property market as well as exports, and the pause in capital outflows.
With policymakers in Beijing cranking up fiscal and monetary gears to defend growth – temporarily at the cost of reforms – the economy is likely to avoid a hard landing.
Warning signs
Red flags are starting to fly from the US corporate sector. US corporate earnings are estimated to have fallen by 6 per cent in the first quarter from a year ago. That would make it the third straight quarter of earnings decline.
Although the energy and materials sectors are largely to blame, there are signs of broad weakness in demand – corporate revenues are estimated to have fallen for the fifth straight quarter.
For sure, there are tentative signs of stabilisation in full-year earnings expectations after several months of downgrades, but this needs to be watched closely.
US wages, which have remained subdued so far, may become a concern over the coming months as the job market tightens.
Also, there has been a perceptible downtrend in US auto sales since late last year, taking the shine off a recent pick-up in manufacturing business confidence.
Japan’s economy has taken a turn for the worse. The quarterly Tankan survey showed manufacturers were downbeat on business conditions and investment spending as the yen rebounded, making exporters less competitive.
Annual spring wage negotiations for manufacturing were disappointing.
There are increasing questions about the Bank of Japan’s ability to revive growth and inflation. This raises doubts about the success of Abenomics – Prime Minister Shinzo Abe’s plans to revive the economy through fiscal and monetary stimulus and structural reforms.
Time to be cautious
All these headwinds warrant caution.
Although equities could still deliver positive returns, the uncertainty surrounding these returns has risen significantly.
After years of adding exposure to equities, we believe it is time to adopt a more balanced approach.
For a multi-asset investor, the recent rally offers an opportunity to shift the risk profile to a more conservative stance, moving towards bonds and alternative assets.
For instance, in our model allocation for a moderately aggressive investor, this has involved reducing our overall equity allocation to 54 per cent from 60 per cent six months ago.
Within fixed income, we have a preference for corporate credit, especially US investment-grade bonds.
In Asia, we would raise our allocation to regional US-dollar-denominated investment-grade corporate bonds.
We are comfortable with this asset class, as the region’s economy remains healthier than other emerging economies such as those in Latin America and Eastern Europe.
This is partly due to the region’s lower exposure to commodities, sturdier external balances and stronger domestic demand.
That said, there is a risk China’s slowdown could lead to a deterioration in credit quality. Hence our preference for investment-grade bonds in the region.
Steve Brice is chief investment strategist at Standard Chartered Bank’s wealth management unit.
