Expansive central banks continue to dominate global markets. Bonds in total worth more than 15 trillion U.S. dollars currently yield negatively worldwide. Fewer and fewer investment-grade bonds are being issued with positive yields. But negative interest rates at the long end and the inversion of the U.S. yield curve point to economic concerns that have also been keeping interest rates low. The unhappy word "recession" has made the rounds in the last quarter, especially in mid-August, according to data on online search queries. Some of the macro data, too, is negative. According to Purchasing Managers' Indices (PMI), the industrial sector has been contracting for some time in many industrialized countries. In Germany, the composite PMI in September fell to its lowest level in seven years. In addition, a near-term revival in capital spending looks unlikely. The continuing trade conflicts between the United States and China and the United States and Europe, together with Brexit, continue to be big disincentives to investment. The attack on two important Saudi Arabian oil plants was a further setback for global confidence. It showed the fragility of vital energy infrastructure and how quickly major supply shocks can occur. In terms of inflation the threat of such attacks are not the desirable demand-pull kind that would alleviate deflationary worries. Rises in oil prices caused by a supply shock would simply hurt consumers and deter spending, adding to the downward pressures on growth.
Inflationary risks, however, have almost been forgotten at present. No amount of money printing appears to drive consumer prices up. But it has contributed to inflation in asset prices. The return on many bonds in recent years has come primarily from price increases rather than coupons. More than 85% of the return on 10-year German government bonds in the past five years has come from rising prices. Now with 10-year Bunds trading with negative yields and assuming yields won't fall further, bond investors would seem to be faced with two possible future scenarios. Either stable yields, giving little to no further return from price increases and therefore a negative total return; or rising yields and a painful fall in bund prices – and therefore again a negative total return: Either way, it doesn’t look good.
Gold is profiting from low real yields
Lower opportunity costs and economic expectations are reflected in lower real yields that are likely to benefit the gold price.
Sources: Refinitiv, DWS Investment GmbH; as of 9/23/19
What about other asset classes? Gold, which tends to be popular with nervous investors in turbulent times, and especially at a time of low real yields (see chart above) for its potential to reduce the opportunity cost of holding the non-interest-bearing yellow metal, is trading at an 8-year high. The Japanese yen, often used as a safe-haven currency, has been appreciating for about a year. Even the most prominent of all cryptocurrencies has had a strong year, reaching its year-to-date high at the end of June, before economic worries peaked and the U.S. yield curve of 10- and 2-year Treasuries inverted. And equities? The S&P 500, is prancing around at its historic high of just over 3000 points. The consensus view is that earnings per share (EPS) will grow by just over 10% next year. We expect only half that. And while the S&P 500 is already at twice its last high before the financial crisis, the MSCI AC World ex USA Index is only slightly higher than in mid-2007, thanks to dividends. Even in the American market there is a fly in the soup: in the past 12 months, only the big caps were on the up: the S&P 500 gained 2.5%, the smaller-cap Russell 2000 lost 8.6%.
Longer-term structural developments have also remained a constant worry for the markets: frailer growth, modest productivity gains, record global debt (319% of GDP in the first quarter) and an aging population in big parts of the world. But calls for fiscal stimulus, which would mean more debt, are getting louder. For the capital markets the implications have been worrying. The conundrum for investors is to generate a positive real rate of return when the 10-year real government yields of all the major industrial nations are negative: Japan at -0.7%, the United States at -0.9% and Germany at -2.1%. Where is yield supposed to come from, the desperate asset manager might ask the equally desperate client?
There is, however, a lot going on below the surface of the main equity indices, within commodities and in different bond maturities and rating classes. We believe the active portfolio manager may have some leeway to tickle a little more yield from the market after all. Equity markets, for example, have been displaying for some time a twofold split in valuations across sectors. Companies seen as having little to offer have a price-earnings (P/E) ratio of around 5, while others trade above 20. The winners keep on winning, the losers are sold on. As a result, the valuation premium of growth stocks over value stocks surpassed July 70% for the first time in July – higher than at the previous peak, in the year 2000. The valuation premium of momentum versus value stocks, which was still at 30% at the end of 2017, is now approaching the 100% mark. As the following chart shows, this year in particular the sectoral trend was highly correlated with 10-year U.S. Treasury yields. The correlation was also evident at the beginning of September, when both curves suddenly reversed. Momentum stocks, which had previously performed extremely well, suffered one of their biggest declines in a few sessions compared to value stocks in a violent rotation of sectors and styles.
Low yields are of little use for value stocks
While the correlation isn't always perfect, this year has shown how much growth and momentum stocks are profiting from lower yields, unlike value stocks.
Source: Refinitiv, DWS Investment GmbH; as of: 9/23/19
What does this mean for asset allocation?
Has the turnaround come? We don't think so. The above-mentioned sector rotation came to a standstill in mid-September and government bond yields tended to weaken again after two surprisingly strong weeks. We assume interest rates will trade sideways over the 12-month horizon and do not expect further violent rotations of sectors or styles while the stock rally persists. Our base scenario remains that we do not expect a recession in the coming twelve months, nor a marked revival in economic growth. In an interest-rate environment characterized by "lower for longer", we believe there is still no way past equities. However, the shaky global economy, unpredictable trade conflicts and Brexit are likely to continue to cause volatility. Our regional preferences remain the developed markets, especially the United States and Eurozone. In the United States we favor growth and quality stocks, in the Eurozone cyclical ones, making our overall portfolio balanced.
For bonds, the situation is clearer after the latest central-bank meetings, but the U.S. Federal Reserve (Fed) continues to have scope to loosen policy further if it chooses. The search for positive yields remains challenging. We see that as an argument for emerging-market hard-currency government bonds. In corporates we prefer euro- to dollar-denominated bonds, not least because the European Central Bank (ECB) is now once again a price-insensitive buyer in the European market. U.S. government bonds and, on the currency side, the Japanese yen for diversification purposes could eventually be considered to be worth contemplating about. Given the low real yields, gold remains a potential portfolio hedge.
Multi-asset allocation for European Investors
Profiting from ongoing trends, seeking opportunities and watching for risks
Source: Multi Asset Group, DWS Investment Management as of 9/10/19
The chart shows how we would currently design a balanced, euro-denominated portfolio for a European investor taking global exposure. This allocation may not be suitable for all investors and can be changed at any time without notice. Alternative investments involve various risks and are not necessarily suitable for all clients or for every portfolio.
Multi-asset allocation for Asian Investors
Profiting from ongoing trends, seeking opportunities and watching for risks
Source: Multi Asset Group, DWS Investment Management as of 5/31/19
The chart shows how we would currently design a balanced, dollar-denominated portfolio for an Asian investor taking global exposure. This allocation may not be suitable for all investors and can be changed at any time without notice. Alternative investments involve various risks and are not necessarily suitable for all clients or for every portfolio.
Prospects remain rather bleak
All three indicators show rather gloomy prospects
For some time now, all three DWS indicators have been almost unanimously pointing to a negative environment. The brightening at the beginning of the second quarter proved to be no more than temporary. The macro indicator has improved a bit but is still negative – for the twelfth consecutive month. The surprise indicator suggests that analysts' expectations for 2019 as a whole were too optimistic and the risk indicator reflects investors' currently low risk appetite. The escalating trade disputes between the U.S. and China are further depressing investor sentiment. Despite some occasional temporary concessions, there are few signs that this serious trade-conflict episode is going to be resolved soon. Even if the tariff dispute between the two largest economies is resolved there is risk of the U.S. targeting Europe next. Further monetary-policy easing by global central banks may be one consolation for capital markets. But for now the bottom line is that the indicators point to a particularly fragile market environment.
MACRO-INDICATOR / Condenses a wide range of economic data
The macro indicator recovered somewhat in August, but remains in negative territory in absolute terms. A slight recent worsening suggests a degree of caution is still required. The macro-indicator traffic light has now been red for more than 12 months.
RISK-INDICATOR / Reflects investors' current level of risk tolerance in the financial markets
The risk indicator has deteriorated significantly since the beginning of the year. The escalation in the trade conflict between the U.S. and China and the deadlines set by the U.S. in the trade conflict with Europe are just two contributing reasons. Continuing uncertainty over Brexit is another. The fact that there has been no marked further worsening of the trade dispute and yet more largesse from the ever generous central banks might explain the indicator's recent recovery: it is now just in green territory. But the recent attack on Saudi oil assets is not yet reflected in these figures.
SURPRISE-INDICATOR / Tracks economic data relative to consensus expectations
The surprise indicator has been red for most of the year. But the regional sub-indicators have diverged substantially. The regions keep changing from negative to positive and vice versa, so that no consistent regional picture can be drawn.
Source: DWS Investment GmbH; as of 9/19/19
1. Purchasing Manager Index from IHS Markit
2. Given a relatively flat yield curve, otherwise some return could be achieved through the "roll-down" effect. See also: https://dws.com/insights/cio-view/charts-of-the-week/cotw-2019/chart-of-the-week-20190802//?setLanguage=de&kid=int.20190524.cio_view.all_glob.textlink.internal-sendout.mXZgBTPWJt45HsRNBU2breyW2Qd7j2
3. Refinitiv, data as of 9/24/19
4. As of 9/23/19.
5. MSCI World Growth Index and MSCI World Enhanced Value Index