26th August 2015
Emiel van den Heiligenberg, head of asset allocation at Legal & General Investment Management explains his team’s view that we are witnessing a correction in global markets rather than the beginning of a prolonged bear market…
Below average growth closer to ‘normal’ than ‘stagnation’
The recent cyclical picture shows few signs that we are climbing out of this low growth world. The effects of the developments in China (the equity rout, the renminbi devaluation and the growth slowdown) will deliver a further modest drag on growth and inflation in the rest of the world.
We are not alone in this ‘lower for longer’ growth outlook. Long-term equilibrium interest rates and inflation expectations have come down as markets priced in this view. When combined with deregulation and improving credit conditions, our long-term growth outlook suggests advanced economy growth will remain below average over the medium term, but importantly closer to ‘normal’ than ‘stagnation’.
A mid-cycle economy sweet spot
We have been tactically cautious on risk due to a combination of risks: anticipation of the first rate hike from the Federal Reserve, concerns about a flare-up in European political risk and Chinese hard-landing risk. For the moment, we are siding with the fall in equity markets being a correction rather than the beginning of a prolonged bear market.
Slow growth has the benefit that it extends the economic cycle – this one is currently six years old and counting – as it takes longer for imbalances to build up. Our proprietary research shows that the sweet spot for risky assets, and especially equities, lies with a mid-cycle economy. In this environment inflationary pressures are non-existent, commodities are usually weak due to excess capacity, central banks have no need to temper growth through aggressive rate increases, credit availability is improving and the risk of a recession is low. Except for the relatively imminent Federal Reserve rate hike, all boxes are ticked for a mid-cycle economy.
‘Mid risk’ assets attractive
Low growth not only lengthens the economic cycles, it also implies an ongoing search for yield. This should support for what we call ‘mid risk’ assets such as real estate, infrastructure and high yield bonds.
The US high yield index is down for the year, mainly for two reasons:
1. Part of the high yield universe contains bonds issued by energy companies. Spreads have widened with a weaker oil price.
2. Issuance in the US credit market has increased as companies want to benefit from the low absolute yields before the Federal Reserve starts raising rates
This provides us with an interesting medium-term investment opportunity in high yield. We expect oil start to bottom out around current levels, and expect both a supply and demand response to start turning the market dynamics around. That implies that the spread widening in high yield is overdone. Defaults will undoubtedly rise from current very low level, especially in energy, but we think it is unlikely that defaults across the entire high yield universe will go meaningfully above their long-term averages. This means that investors are compensated for higher default risks in higher spreads today.