Chief Investment Strategist and Chief Economist
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We’ve increased our tactical weighting to equities to neutral, while underweighting fixed income. Here’s why.
The Citi Private Bank Global Investment Committee raised its allocation for global equities to neutral by reducing the fixed income allocation (now underweight by 2%). Cash and Gold remain overweight by 0.5% and 1.5% respectively.
Since we eliminated our fixed income overweight at our August meeting, global bond returns have been negative and most bond yields have risen slightly. While we don’t expect losses for most diversified bond investors in the year ahead, global bond yields - including emerging markets and high yield debt - have fallen to a record low 1.6% (0.6% ex-US). After deepening our underweight in mostly negative-yielding European government bonds last month, this month, we reduced the size of our overweight in short-term US Treasuries and some short- and intermediate-duration investment grade corporate bonds.
In contrast to the decline in bond yields, equity dividend yields have changed minimally, while dividends per share continue to grow at a mid-to-high single-digit pace.
The drop in bond yields – which has extended strongly to the corporate sector – does not in any way guarantee share price gains. We continue to see a modest near-term contraction in manufacturing activity negatively impacting EPS, but a recovery within the coming year. We believe global equity underperformance over the past 12 months – with shares up just 2% from a year ago compared to a 11% gain for global bonds - meaningfully discounts this. Investor caution and fears of recession remain evident in a wide range of measures.
Importantly, monetary and trade policy were the primary drivers of US recession risk in our view. The turn to easing by the Fed, numerous other central banks, and a likely more cautious approach to trade negotiations, is a driver of our changed portfolio views. The apparent lowering of US policy risks compared to our concerns earlier in the year, lower borrowing costs broadly, and weaker investor risk positioning led us to reduce the bond allocation in favor of equities, even as we remain overweight in US dollar fixed income.
As we noted in recent months, low inflation, solid demand and few excesses mar the global economic expansion. To the extent this endures, the global manufacturing contraction will be limited. The recent fall in long-term US bond yields to levels below short-term yields (so-called yield curve inversion) is a highly reliable signal of Fed easing steps. The probability of it signaling recession would be greater if the Fed ignored this concern without reducing rates. Apart from the yield curve, a wide breadth of US leading economic indicators are positive. Risks always remain, but we expect the Federal Reserve to succeed in extending the US economic expansion into 2020.
In the past week, global equity and credit markets reacted calmly to the largest one day gain in the price of crude oil in a decade. This came on an attack on Saudi petroleum infrastructure that sidelined half of the country’s production. The risk of further attacks and a wider conflict in the Middle East remains a risk. However, the oil price merely rose to a high last seen in May of 2019. As discussed in detail in our Strategy Bulletin – the direct damage itself looks short-term in nature. We believe the calm response in markets (apart from petroleum) in part signals investor pessimism, measured by significant equity fund outflows this year.
With this noted, equites declined by very little in the summer months as key economic indicators weakened. With our expectation that EPS rises a mere 4% in 2020, we would not expect a high equity return in the year ahead. This contrasts with periods as recently as 2017 or early 2019, which followed deeper corrections. Our expectation for the one-year global equity total return is centered in a range around 6-7% as a base case. As such we expect equity dividend yields to drive a greater-than-usual share of total returns. After a period of outperformance for interest-sensitive defensive industries, we expect a somewhat stronger relative performance for cyclical industry sectors. With bond yield declines driving certain defensive shares higher, we would select shares with sustainable dividend growth over those with the highest absolute yields.
The GIC has added back to US and Japan equities where dividend growth rates look particularly attractive, and to a small extent in the UK, where yields are high and valuations low. Severe politically-driven economic risks remain for the UK, but the Pound has fallen to near three-decade lows on these concerns. Valuations favored taking slightly greater risks in a widely diversified portfolio with larger shifts likely as events unfold.