For w/e 26th April, global equity funds registered a fourth, consecutive week of outflows as rate cut hopes continue to fade. The yield on the US Treasury 10y bond hit just over 4.70%. Thursday saw carnage as the US Q1 GDP release came through. Although at a headline level the GDP figure appeared disappointing rising by just 1.6% y/y (vs Q4 2023: +3.4% y/y), actually, cutting through the data shows domestic demand remains strong (rising a healthy +2.8% y/y), retail housing construction rose almost +14% y/y and business investment (CAPEX) +3.0% y/y. The drag was largely down higher imports (helped by a strong US$). If you exclude inventories (down nearly $20bn), government spending (down to 1.2% y/y from 4.6%) and trade (-0.86% from GDP), GDP grew +3.1% y/y (vs Q4 2023: +3.3%). Price pressures (as measured by the Fed’s favourite gauge) picked up with headline PCE inflation rising to 2.7% y/y (Feb: 2.5% y/y) while Core PCE inflation is rising 3.7% (Q4: 2.0%). The job market shows no signs of letting up as jobless claims for w/e 20th April dropped -5,000 to 207,000 (215,000 had been forecast); the savings rate fell to 3.6% in the quarter (from 4.0%) as consumers continue to spend away.
Given the current environment of heightened market volatility, it’s not surprising there is a negative sentiment out there over how much further markets can rise. There are never-ending gyrations around interest rate cuts, the stickiness of inflation and just how much steam the consumer has left on the spending front. There are jittery investors out there asking what is the likelihood my portfolio will grow 10% this year and 10% next. This week, I have given three presentations – two of them to existing investor groups and a third to prospects centred around Impact Investing (II). All three centred around Asset Allocation (AA) and what can be done to preserve wealth (returns) in real terms (i.e. in excess of inflation) while at the same time finding ways of de-risking portfolios (liquid, semi-liquid and illiquid) against the ongoing perils of geopolitics, rates & inflation. All three presentations ended up taking a life of their own but, they invariably converged around certain themes. I will try to summarise it as follows:
In a normal environment, any economy would try and grow its way out of a tight spot. Today, the economies with the strongest growth rates are, for the most part, to be found in Emerging Markets (EMs). A broad range would be around 4.5% for China and just under 7% for India this year. Other Ems fall somewhere inbetween. The IMF reported Asia will contribute roughly 60% of global economic growth this year. The ASEAN-5 (Indonesia, Malaysia, Philippines, Singapore & Thailand) are forecast to rise 4% to 4.5%. Vietnam is actually viewed being closer to 6%. Investment will largely drive GDP in India and China while private consumption will be the primary engine for the other markets. Indeed on Thursday, South Korea saw Q1 GDP rise +1.3% q/q marking its fastest expansion since Q4 2021. Domestic demand was the main factor with a +0.8% q/q rise in private consumption. The economy grew 3.4% y/y (Q4 2023: 2.2% y/y) and exports expanded +0.9% q/q (Q4 2023: -3.5% q/q).
This is not the case for Developed Markets (DMs). At the last count (IMF), projections for 2024 for the US was 2.1%, Euro-Area 0.9% (Germany 0.5%, UK 0.6%, France 1.0%), Canada 1.4%, Japan 0.9% and other advanced economies 2.1%. These same countries/regions simply don’t have enough growth power to overcome their vast & growing debt loads. So, for them, what’s the answer? It has to be productivity!
So, from a portfolio construction viewpoint, you need a fixed income component that is reliable and an equity (and/or equity-like) component that can grow. The problem is that fixed income has been severely challenged by the events of the last 2 years (basically from Russia’s invasion of Ukraine onwards) resulting in inflation which has sent bond yields spiralling through the roof (i.e. bond prices have collapsed). So, seeking protection from bonds has been a nightmare! This still continues – the US 10y bond is yielding close to 4.70% and looks set to go higher. There will come a point to buy – but right now it’s feeling premature. Contrary to what textbooks tell you, bonds and equities have been going up and down in an almost synchronised manner. In 2022, the bond portion declined even more than equities leaving investors perplexed why their portfolios had fallen so much. Add insult to injury, if you were/are in UK bonds, you suffered the double-whammy of the short-lived, nightmare saga of Liz Truss’s government and the then Finance Minister, Kwazi (Kamikaze) Kwarteng’s failed experiment on tax cuts with no attempt at balancing the books.
So what do you do? This is where out-of-the-box thinking comes into play:
If you HAVE to be in daily dealing investments, keep your fixed income exposure short duration i.e. maturities under two years. Even this is not guaranteed to avoid the clutches of rising yields BUT it is less sensitive to rate movements. You can still find Short Duration bonds offering distribution yields of between 4.20% and 4.70%. Furthermore, if/when rate cuts come, these will give capital appreciation.
But if you DON’T have to be in daily dealing products – and can afford to be without access to immediate liquidity while settling for 3-month to 6-month time horizons – then private debt opportunities are really worth considering. These pay out yields of between 7% and 10% (occasionally/exceptionally higher if you consider deal-by-deal opportunities through Note Structures). The opportunities are wide-ranging and cover microfinance (for the betterment of the underprivileged), trade finance (to facilitate trade with companies in countries that struggle to receive credit), factoring/invoicing (that benefits Small-to-Medium-Sized entities in need of liquidity) and property (focusing on energy-efficient buildings) – to name a few. These latter opportunities formed the backbone of my Impact Investment presentation! By considering such deals, you achieve two things – (1) you build a fixed income book that does exactly what fixed income is supposed to do – giving you a yield of 7% to 10% and (2) at the same time, exposure to II (Impact Investing). That’s two with one slingshot! It changes the risk dynamics as well. For instance, a portfolio that is 100% Fixed Income earning say 8% (mid-point), gives you a staggering 8%. A daily dealing portfolio invested 100% in short duration bonds would give you 4% (assuming a 4% distribution yield)! You get half. This gives you a vital choice – to spend that on taking risk or to bag it. It’s a quality problem to have.
If you’re happy with the full 8% - and why wouldn’t you be - then there’s no need to go any further. However, if you have appetite for risk then you might decide I will do a split – 50% in Fixed Income (earning me 4% i.e. 50% of 4%) and the other 50% in Equities. Remember, you can play around with the proportions as you see fit. In my opinion, the most attractive, productivity-enhancing opportunities out there lie in AI. We have had the “excitement” rally (triple digit returns and all that). The next stage will be the adoption and implantation of AI technologies across numerous sectors and sub-sectors. Many of the latter themselves have an underlying Impact theme e.g. the use of AI in the analysis of medical scans and tests, the development of robots to replace humans in areas where high work casualties are a major problem…..it’s limitless. AI will find new uses and new markets while expanding existing ones. It’s not all about technology – Europe is turning around. It trades on very low valuations (circa 13X vs the US at 23X). The Euro has room for appreciation too. EMs, especially in Asia (see earlier comment above about growth rates) are on roughly similar valuations as Europe. Their currencies too have potential for upside. Japan, despite its stellar rally in 2023, is also on modest valuations – and now it embarks on interest rate rises, a whole new era for Japan.
In summary, think out of the box……redefine how and where you extract yield (Fixed Income) and think selectively where you invest in growth plays. The next two years, largely on the back of technology (AI, Robotics and Biotech) is going to change how companies operate. This is “dot.com part deux”.
