Compass Q1 2019 - Barclays Private Bank
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Compass
Private
Bank
Q1 2019
Contents 5 Welcome letter 6 Capital markets drizzle – Review of 2018, Preview of 2019 8 Developed Markets Equities: borrowed time? 10 A reversal for Emerging Markets Equities? 12 Inflation – an opportunity or a threat for investors? 14 Is King Dollar about to be dethroned? 16 Brexit – a new dawn? 18 Theme #1: Blue Chips 19 Theme #2: Emerging Asia 21 Theme #3: European Banks 22 Theme #4: Japanese Equities 24 Theme #5: The ‘Fourth Industrial Revolution’ 26 Theme #6: US High Yield 28 A more appealing defence – Our TAA positioning 31 Appendix 32 Interest rates, bond yields, and commodity and equity prices in context 34 Barclays’ key macroeconomic projections
“Simply ‘showing up’ as
an investor, in a sensibly
diversified fashion, and
staying the course, is
the trick.”
4 | Compass Q1 2019
December 2018
After a sustained period of almost perfect calm in capital In this publica tion, we examine the year just gone in a little
markets, with most assets riding on the coat-tails of a more detail and preview the one ahead. Slower economic
synchronised acceleration in global growth, 2018 has (and corporate earnings) growth seems to lie in wait, but
provided a very different experience for investors. While the no recession is visible just yet. If one arrives tomorrow, our
US economy surged on the back of a dose of fiscal sugar, portfolios will not face it as a fearless all-in bet on a glass-half-
growth rates in large parts of the rest of the world economy full view of the world. Nonetheless, we still see moderate risk
swooned for a variety of reasons. portfolios being best served by tilting gently towards stocks
around the world.
Central bankers and bond markets provided significantly less
accommodation while the US administration added some bite We hope you enjoy this publication. As ever, this comes with
to their repeated barks over trade tariffs. All of this has added our best wishes for the festive season.
up to a more difficult environment for capital markets, which
offered few refuges from the turbulence for most of the year.
Warmest regards,
Unfortunately, times like these are part and parcel of investing.
Some years will be amazing, offering near stress-free gains
across asset classes, such as 2017. Some years – like 2008 –
will be horrible. Most will be somewhere in between, but there
have been many more good days, months, and years than
there have been bad ones. Simply ‘showing up’ as an investor,
in a sensibly diversified fashion, and staying the course, is
the trick.
Jean-Christophe Gerard
For our part, we will strive to capture the best opportunities
Head of Investments
in different market circumstances. Prudently-constructed
portfolios, founded on solid asset allocations and backed by
rigorous due diligence, are still, we think, the best long-term
investments for an uncertain world. And they are precisely
what we offer our clients.
Compass Q1 2019 | 5
Investment Strategy
Capital markets drizzle – Review of 2018,
Preview of 2019
If the experience of investors could be described in meteorological terms, 2018 would
surely be represented by cold drizzle punctuated by infrequent, but fairly terrifying,
thunderstorms. The reliably warm and nourishing sunshine of 2017 is long forgotten.
While this year has mostly proved tough going for investors (Figures 1 and 2),
of course, not everyone has been miserable.
The doomsayer trade, parched by a crisis-free 2017, is clearly feeling replenished by a year that has so far managed to provide both
negative headlines and a few more fundamental factors to worry about. As we have pointed out elsewhere, some of these fears look
overblown to us. With the next recession still not yet visible on the horizon, the onus remains on investors to find ways to profit from
ongoing economic growth. Equities remain the most attractively priced option here. For their part, bonds are providing slightly more
appealing shelter from the storms that could always lie in wait.
Why has 2018 been so difficult?
Just as there were several contributing factors to the makings of 2017, from a synchronised surge in global economic growth to
a more amenable bond market, so 2018’s difficulties stem from a variety of sources. The most marketable cause of the trickier
investing backdrop in 2018 is, of course, the trade war. Any story involving the 45th President tends to draw readership, particularly
those stories where he is perceived to be destabilising the old world order as promised on the campaign trail. What works for the
media also tends to force the agenda for an investment services industry naturally hungry for free airtime. In the trade war, both
sides of the table have found something they can write and talk about seemingly inexhaustibly. Trade war is the new Brexit.
Much like Brexit, the trade war’s importance to the world’s capital markets has been exaggerated so far. China’s mostly deliberate
economic slowdown, a correction in bond prices, and several transitory bumps in the road for Europe have all been both unrelated
to trade tensions and likely more important factors for investors to consider. The fact that, in sentiment terms, investors entered the
year with little in the way of a cushion to absorb these negative shocks to their outlook has further added to the market malaise.
Why should next year be any easier?
The political sphere may well remain capricious in 2019; it certainly seems unwise to bet against it. Though our recession
indicators are not yet flashing amber, there are a few signs that we are in the late stages of this already elongated economic cycle.
While the US consumer and the banking sector have remained more chaste in the aftermath of the Great Financial Crisis, the
world’s corporate sector has borrowed heavily (Figure 3). US interest rates might creep nearer to the point where they should start
to deny the US and global economy the oxygen required for further strong growth.
FIGURE 1: Most major asset classes are negative year to date…
Cash & Short-maturity Bonds 0.8%
1.5% 2017
Developed Government Bonds 2.1% 2018 (through to 25 Nov)
0.4%
Investment Grade Bonds -1.8% 5.7%
High Yield and Emerging Markets Bonds -2.4% 10.6%
Developed Markets Equities 22.4%
0.7%
Emerging Markets Equities 37.3%
-12.0%
Commodities 1.7%
-3.5%
Real Estate 10.4%
-1.0%
Alternative Trading Strategies -3.7% 6.0%
Source: Morningstar, Barclays
Past performance is not a reliable indicator of future returns.
6 | Compass Q1 2019
Investment Strategy
FIGURE 2: …while equity volatility has spiked FIGURE 3: US corporate leverage has been steadily rising
45 220 Percent Percent of GDP 48
VIX 5-year average
46
40 200
44
35 180 42
30 40
160
25 38
140 36
20
120 34
15 32
100
10 30
5 80 28
1980 1985 1990 1995 2000 2005 2010 2015
0
US non-financial listed equity - net debt/EBITDA
2013 2014 2015 2016 2017 2018
Non-financial corporate business - debt outstanding (rhs)
Source: Datastream, Barclays
Source: Datastream, Barclays
However, the first point is that we enter these trials, and likely Investment conclusion
more besides, burdened with considerably less exuberance.
The world economy’s underlying health is, if anything, being For now, we still find more to smile than frown about in
slightly underestimated by the world’s investors. In particular, the 12 month outlook for investment returns. Finding the
the prospects for emerging market corporate earnings growth appropriate perspective for the many threats that are (always)
are a little bit brighter than many seem to fear. Meanwhile, ranged against the global economy remains the toughest
the swoon in the European economy may owe more to challenge. Remembering that the media’s agenda may not
transitory factors than is widely realised. It is set to be another be compatible with your own as an investor is likely a useful
difficult year politically for Europe, but this is well known start. Augmenting this with a reminder that the threshold to
and should be factored into asset prices. Some of the upside bet against global growth should be high is also important.
potential for European integration however looks less well We exit 2018 well positioned for disappointment in many
understood and priced. areas of the world’s capital markets. If such gloom does not
fully materialise, as we still expect, stocks should continue to
outperform bonds. We explore this in a little more detail in the
five themes detailed in this publication.
“Though our recession indicators are not yet flashing amber, there are a few signs that we
are in the late stages of this already elongated economic cycle.”
Compass Q1 2019 | 7
Investment Strategy
Developed Markets Equities: borrowed time?
According to the indicators that have been of some use historically, the next recession
is still not visible on the horizon. The outlook for global economic growth is decent.
We expect the US fiscal sugar high to ebb, slowing the all-important US economy from the pace seen this year. However, the
Chinese economy looks capable of levelling out at a more sustainable pace, while Europe should continue to trundle along at
a little above its potential growth rate. This economic outlook, characterised by increasingly normal monetary policy, remains
sufficiently healthy for us to continue to tilt our portfolios towards stocks. Nonetheless, there are several buts...
Earnings growth largely depends on two factors – sales growth and profit margins. Given today’s high run rates, both are set to
look more challenging for developed equities next year. The largest chunk of this slower revenue growth should come from the US,
where the ebbing tailwind from this year’s fiscal easing should start to bite. This slowdown shouldn’t come as a major surprise to
investors, as it is already assumed in forecasts.
Meanwhile, we suspect that margin pressures are set to become a little more urgent. Profit margins have long since rebounded
from the Great Financial Crisis and now sit close to cyclical peaks (Figure 1). Even in Europe, where profitability has been slow to
rise off the floor, there is simply less to go for after a year of recovery. While noting above that the next recession is not yet visible
on the horizon, the scope for the developed world economy to grow without generating more meaningful inflationary pressure
looks limited. Economic slack, from labour forces to factories, has been more or less used up.
This story is evident in the returning bargaining power of developed world employees. It is most obvious in the most visibly tight
labour market of the US, but also in Europe, where evidence of rising wages (and employment costs) is multiplying (Figure 2).
With further falls in unemployment, and accompanying wage rises likely coming in 2019, margin pressure should become more
intense over the course of the year. This is also an area where consensus expectations may jar with reality a little too. Consensus
still expects further margin expansion from here, suggesting scope for some disappointment. To be sure, such disappointment
is not an unusual sentiment for the world’s equity analysts and earnings forecasters. As an aggregated community, they are too
optimistic every year. However, again, this is likely an unhelpful factor.
FIGURE 1: Developed equity margins already at cyclical
highs
11 (%)
10
MSCI World - net profit margins “We still expect developed
9 equities to outperform cash next
8 year. We continue to position our
7
tactical portfolio accordingly.”
6
5
4
2006 2008 2010 2012 2014 2016 2018
Source: Datastream, Barclays
8 | Compass Q1 2019Investment Strategy
FIGURE 2: Wage pressures firming across developed world We still expect developed equities to outperform cash next
year. We continue to position our tactical portfolio accordingly.
3 Year-on-year (%) However, increasing headwinds to revenues and margins are
likely to make for another year of tough sledding. Relative to
2 the beginning of 2018, we are helped by a greater sentiment
cushion. Investors are far from exuberant and that will make
1
any disappointments easier to absorb without market turmoil.
0
-1
Annual wage growth (average of US, UK, JP, EZ)
-2 3-month moving average
-3
2009 2011 2013 2015 2017
Source: Datastream, Barclays
Compass Q1 2019 | 9Investment Strategy
A reversal for Emerging Markets Equities?
Emerging Markets (EM) Equities have certainly had a tough 2018. Year-to-date,
EM equities have underperformed against the US by around 15%, a sharp contrast to
the astounding double-digit relative returns from 2017. With hindsight, we can say that
a confluence of factors – escalating trade tensions, moderating growth and currency
crises – have weighed on returns more than we’d anticipated.
However, we think that EM equity underperformance has become overstretched relative to its fundamental prospects. In In Focus
– Betting on reversal: Emerging Markets versus the US, we observed that divergences of such magnitude usually reverse in favour
of EM. EM/US divergences like the one we’ve seen this year aren’t common, but neither are they unprecedented (Figure 1). Since
1988, we’ve seen roughly 10 divergences of similar magnitude. On average, these divergences usually take place in a span of 7-9
months, with EM equities eventually rallying or outperforming more than half of the time. The only times when EM continued to sell
off heavily was in the 1997 Asian Financial Crisis or the bursting of the Tech Bubble – a repeat of either scenario seems unlikely to us
right now.
Besides that, we’ve also highlighted how market sentiment was probably too pessimistic, and that given the scale of EM’s
underperformance, a lot of bad news has likely been priced in. However, recent price movements suggest a tentative stabilisation
in sentiment. Despite continued volatility within Developed Markets Equities, with the US tech sector enduring a heavy sell-off
recently, EM equities have been roughly flat – an observation worth noting since EM equities on average, tend to underperform
when US equities experience drawdowns of these magnitudes.
FIGURE 1: Past episodes of EM-US divergence
Divergence EM vs US relative returns
6m/6m (%)
50
40
30
20
“We think that EM equity
10 underperformance has become
0 overstretched relative to its
-10 fundamental prospects.”
-20
-30
-40
1988 1993 1998 2003 2008 2013 2018
Source: Datastream, Barclays
Past performance is not a reliable indicator of future returns.
10 | Compass Q1 2019Investment Strategy
Consensus expectations for earnings growth currently stand current macro conditions, and EM equities currently offer
at around 10%, a passable hurdle in this current growth a better risk/reward opportunity relative to other regions
environment. We should certainly be prepared for some of within the wider asset class. Consequently, we have recently
the threats from 2018 to spill over into 2019. Trade tensions increased our overweight exposure to EM equities within our
may persist. Meanwhile, the latest set of Chinese growth tactical positioning, by selling some US equities. The move has
data continues to moderate, implying further downside contributed positively to returns over the past month given
risks for the first half of 2019. Our take is that the scale of a slight reversal of EM/US performance, and we intend to
EM underperformance probably means that a substantial maintain the exposure in anticipation of that trend continuing.
proportion of these risks have been priced in. On balance, we
think that there is scope for a recovery in EM equities under
Compass Q1 2019 | 11Investment Strategy
Inflation – an opportunity or a threat for
investors?
With inflation closer to central bank targets, we still observe that investors are relaxed
about the potential risks of inflation overshooting expectations. How does this
affect investor behaviour? Are there relative value fixed income opportunities from a
tactical standpoint?
Post-Crisis inflation has been persistently low across regions. While most central banks operate under an inflation target, we have
now had an extensive period where inflation has been falling short of these inflation targets by a wide margin. As a result, we
have seen that in the period of 2012 to 2016, ‘expectations’ of future inflation have gradually been drifting lower (‘de-anchoring
of expectations’ in central bank speak). For very good reasons it has been almost a decade where investors have not had to worry
about inflation overshooting targets or even expectations. But with inflation data closer to central bank targets, and wage data
starting to show signs of slowly increasing wage pressures, might investors potentially be a bit too complacent?
In the US, where the unemployment rate is incredibly low and the economy powering ahead, one would expect inflation risks to
start building. Inflation expectations further out are currently about 2%, up from levels closer to 1.5% two years ago (Figure 1).
However, for most of the time over the last decade they have been north of 2.5%. These expectations would normally average a bit
above the central bank target. In this case, where the Federal Reserve has a dual mandate with an inflation target of 2% on private
consumption expenditure (PCE), the consumer price index (CPI) equivalent would be closer to 2.4%. Add on a small risk premium
for inflation risks, and we get to an average of inflation expectations in capital markets that has been fluctuating around 2.5%.
An obvious question is: should investors demand a higher or below average inflation risk premium at this point in time where,
for example, the Federal Reserve’s independence is being challenged by comments and opinions from the US president?
More recently, with energy prices dropping by more than 25% in a short space of time, investors have re-valued inflation-linked
products lower as well (Figure 2). Although a shock to energy can have a large impact on near-term inflation prints, as energy is
FIGURE 1: US inflation expectations FIGURE 2: Time to go ‘long’ US inflation?
3.50 (%) 2.20 (%)
2.10
3.00
2.00
2.50
1.90
2.00
1.80
1.50 US inflation expectations 1.70
US Break-evens (Treasury - CPI Linked Treasury)
1.00 1.60
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18
Source: Bloomberg, Barclays Source: Bloomberg, Barclays
12 | Compass Q1 2019Investment Strategy
about 8% of the inflation basket, its lasting impact for the next
10 years should be non-existent. Energy prices would have to
keep on falling at the same rate for inflation to stay at the same
level. Also, given that real interest rates have been rising over
2018 with the 10-year real interest rate now at 1.1%, does this
provide an opportunity to switch US Treasury holdings into
inflation-linkers?
As inflation expectations are on a way to normalisation, and “We feel that the recent drop in inflation
while investors are still somewhat conditioned on the past expectations may provide an opportunity
decade, we feel that the recent drop in inflation expectations for investors to re-assess investment
may provide an opportunity for investors to re-assess choices of US Treasuries versus inflation-
investment choices of US Treasuries versus inflation-linkers. linkers.”
Compass Q1 2019 | 13Investment Strategy
Is King Dollar about to be dethroned?
2018 has been a year of general US dollar strength. Is this momentum likely to last
into 2019?
The Federal Reserve has been confidently raising interest rates, while the rest of the developed world’s central banks have been
reluctant to embark on the same path of tightening. A number of these central banks are expected to start normalising policy rates
in 2019, including the European Central Bank and the Swedish Riksbank. However, with rate hikes from the likes of the Bank of
Japan or the Swiss National Bank (and others) a distant prospect, interest rate differentials have been increasingly favourable for the
US dollar (Figure 1).
In addition to lifting interest rates, the Federal Reserve has also succeeded in lifting expectations for the pace and the final
destination. In our view, financial markets have now priced in much of the hiking path of the Federal Reserve.
An already healthy economy has been supercharged this year through fiscal accommodation by the Trump administration.
However, these tailwinds will start to wear off in 2019; with a stronger exchange rate, higher real interest rates and higher
monetary policy rates, can the economy continue to fly at the same pace with these tighter monetary conditions? Could we see
the Federal Reserve potentially decide to pause, or at the very least, dial down expectations?
With most central banks in the developed world a few years behind the Federal Reserve, we have begun to observe more
encouraging and widespread improvements in the labour and wage backdrop outside the US, which could spur an increase in
expectations for future interest rate hikes across developed markets (Figure 2). Coupled with the Fed’s monetary policy path being
priced in, interest rate differentials are unlikely to continue materially rising through 2019. Looking at what markets anticipate and
the prospects of momentum to slow, it looks to us that the US dollar’s reign as king could potentially be over.
However, the scenario as outlined above is conditional on a few baseline assumptions. Where could it break down? First, if there
was a global downturn, the US dollar would likely strengthen as a result of safe-haven flows. Second, if trade tensions
FIGURE 1: Interest rates differentials supportive for USD FIGURE 2: Encouraging wage growth dynamics, even outside
the US
2.50 (%) (%) US wage growth (hourly earnings, YoY)
4.00
Federal Reserve policy rate
UK wage growth (labour cost, YoY)
2.00 ECB policy rate 3.50 Euro zone wage growth (Labour cost, YoY)
BoJ policy rate
1.50 3.00
Riksbank policy rate
1.00 2.50
0.50 2.00
0.00 1.50
-0.50 1.00
-1.00 0.50
2012 2013 2014 2015 2016 2017 2018 2012 2013 2014 2015 2016 2017 2018
Source: Bloomberg, Barclays Source: Bloomberg, Barclays
Past performance is not a reliable indicator of future returns.
14 | Compass Q1 2019Investment Strategy
re-escalate, it would also likely result in a stronger US dollar.
And finally, the transmission effect via fiscal policy may take
longer to wear off than we anticipate.
For now, financial markets have priced in a lot and, given the
divergences observed last year, we believe the US dollar has “Looking at what markets
little upside from here. Whilst we are not yet at the juncture anticipate and the prospects of
to express a broad based disliking for the US dollar, we are
momentum to slow, it looks to us
looking opportunistically for currency pairs against the US
that the US dollar’s reign as king
dollar where we feel capital markets have moved ahead of
themselves.
could potentially be over.”
Compass Q1 2019 | 15Investment Strategy
Brexit – a new dawn?
For investors, Brexit can perhaps be seen as an example of the availability bias. This
refers to the idea that the recollection of immediate examples, while often ignoring
other relevant information, can prejudice our reasoning and future decision making.
Essentially the more newsworthy, or simply recallable an event or process is, the more importance we will tend to give it when we
are making a related decision. Brexit is such a seismic event for citizens of the UK, that it may feel bizarre not to give it the same
degree of importance in our investing lives.
The media, of course, can help further this sense. They are bound only to report on the ‘interesting’ stories rather than
proportionally promote the important ones that will make us more clear-headed and successful investors – there would surely be
a revolt amongst media sector shareholders if management decided to pursue the latter policy? Anyway, Brexit has proved itself to
be a very interesting story and will likely continue to dominate the newswires for the foreseeable future.
However, from a capital markets perspective, much of the bad news is now priced in. A reasonably well covered dividend yield
of nearly 5% for the FTSE 100 (Figure 1), suggests value if doomsday does not arrive as we still suspect. There are certainly
headwinds for FTSE outperformance beyond Brexit. The index composition remains too defensive for those looking for exposure
to an economic cycle that retains a healthy pulse. Besides which, the commodity exposure, usually a source of a decent cyclical
kicker, looks unlikely to be a source of much earnings cheer for now. However, patient value investors will like the dividend and
should warm to the fact that this payment has historically grown at around the pace of global nominal GDP. High single digit
annual percentage returns are not to be sniffed at in a world where long end gilts are still struggling to provide you with returns
above inflation (Figure 2).
FIGURE 1: UK stocks offer a decent dividend yield FIGURE 2: UK gilts struggle to offer real returns post-Crisis
6 Dividend yield (%) 6 (%)
MSCI United Kingdom 5
UK 10y gilt yields minus UK headline CPI
4
5
3
2
4 1
0
-1
3
-2
-3
2 -4
2000 2002 2004 2006 2008 2010 2012 2014 2016 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Datastream, Barclays Source: Datastream, Barclays
Past performance is not a reliable indicator of future returns.
16 | Compass Q1 2019Investment Strategy
Sterling will have a role to play in the short run for sure.
Translated profits may fall if sterling durably breaks above “For those able to look through
its post-Brexit range, but only temporarily. This is close to the noise, some exposure to UK
irrelevant from a transactional perspective as most of these assets will continue to provide
companies are not manufacturing in sterling and selling in important diversification, and
other currencies. For those able to look through the noise, in the long term, return for
some exposure to UK assets will continue to provide important investors.”
diversification, and in the long term, return for investors.
Compass Q1 2019 | 17Investment Strategy
Theme #1: Blue Chips
Overview
• Persistently low inflation post-Crisis may have caused investor complacency over inflation risks.
• Stocks which exhibit pricing power can provide a degree of protection to risks of inflation.
• Brand image and market position are helpful determinants of a company’s pricing power.
The outlook for inflation
Post-Crisis inflation has been persistently low across geographies. As central banks have fallen short of their inflation targets for
a number of years, inflation expectations have gradually been drifting lower. However, the unemployment rate in the US remains
at historically low levels with few signs of easing. Absent a material deviation from its target, we still expect monetary policy to
be normalised gradually and for bond and stock markets alike to be able to digest this. However, there are certainly less investor-
friendly scenarios; with incoming inflation data closer to central bank targets and wages starting to show signs of the increasingly
scarce supply of willing workers, are investors becoming complacent with the risk of an inflation overshoot?
Hedging against inflation
Combatting inflation risk can be tricky – there is no single investment that serves as a perfect hedge in all periods of inflation.
However, stocks with pricing power can provide some measure of protection in the context of a balanced portfolio. Portfolios
currently consisting solely of the higher quality corners of the fixed income complex or cash will still be struggling to make a
positive real return. For example, the UK 10-year nominal gilt yield is currently around 1.25% and UK CPI inflation, which has eased
from its peak, remained at 2.4% for November (Figure 1), meaning that the holder is losing over 1% in real terms per annum*.
Our research indicates that during periods of high inflation, equities typically outperform bonds, with the latter offering investors a
negative real return – particularly during periods of exceptionally high inflation like we saw in the late 1970s and early 1980s.
Pricing power
Investors concerned about the prospect of inflation should consider tilting their equity exposure towards companies with strong
business models and pricing power that are able to pass higher input costs on to their customers. We believe stocks with these
characteristics are well positioned to outperform the overall stock market during inflationary periods. The main determinants
of pricing power, in our view, are a firm’s brand image and market position. Certain companies have built up considerable
brand loyalty over time and are therefore more likely to be able to raise prices without losing business to competitors. Luxury
goods companies are another prime example of this.
Likewise, companies that are technology leaders in FIGURE 1: Inflation has drifted higher
their respective fields have the capability to raise prices 3.5 CPI inflation (year on year, %)
if conditions dictate. Competitors find it very hard to 3.0
US
replicate their products and so these firms are in a 2.5 Eurozone
powerful strategic position. In such a context, investors 2.0 UK
are best served by owning a basket of liquid, blue-chip
1.5
stocks with these characteristics, diversified across
1.0
different sectors and regions.
0.5
0.0
* Past performance is not a reliable indicator of future -0.5
returns. -1.0
Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18
Source: Datastream, Barclays. As at December 2018.
18 | Compass Q1 2019Investment Strategy
Theme #2: Emerging Asia
Overview
• Emerging (EM) Asia is a leveraged bet on global growth due to its highly cyclical composition.
• Whilst unhelpful, the world economy can likely digest a further trade escalation.
• Investor sentiment is excessively weak as leading indicators point towards robust growth.
Desynchronising Growth
After reaping the benefits of synchronised global growth in 2017, EM equities have stumbled since amidst slower than expected
growth, higher US rates and increased risks surrounding trade protectionism. The improving economic backdrop for the region
appears to have paused, temporarily in our view. Recent economic data for the smaller open economies like Korea and Taiwan –
who last year were beneficiaries of the region’s export-led growth recovery – have shown early signs of slowing momentum, but
still remain positive for now.
Trade truce
The ongoing tit-for-tat tariff announcements between the US and China has dominated headlines and commentaries alike
over recent months. It is probably wise to have muted expectations for any sort of lasting agreement here. Although, a US
administration deprived of its ability to dictate the legislative agenda by the midterm elections may need to strike a more
conciliatory posture on trade to help stave off darker economic times ahead of the 2020 Presidential election. The likely point for
investors here is, despite of course being unhelpful, the world economy can likely digest a further escalation in trade tensions
and the associated tariffs. At the same time, Chinese policymakers are currently in a difficult balancing act – attempting to reduce
leverage in the economy and curb financial stability risks one on hand, whilst trying to stimulate economic growth and restore
market confidence on the other. So far they’ve demonstrated sufficient control in the policy levers they have available, which has
led to a gradual slowdown rather than anything more sinister.
Cyclical sector composition
Growth expectations have moderated, but leading indicators continue to point to a healthy economic backdrop. In our view,
investor sentiment has become excessively weak towards a region which comprises of a large proportion of (non-commodity)
pro-cyclical sectors levered to the global growth cycle. Unlike EM Latin America (which is heavily exposed to unpredictable
movements in commodity prices), or EM EMEA (which has a less cyclical composition), the EM Asia index boasts more than 65%
of its constituents in the more desirable sectors such as technology, financials, and industrials (Figure 1).
FIGURE 1: EM Asia has a cyclical sector composition
100%
90%
80% Real Estate
Utilities
70%
Communication Services
60% Information Technology
Industrials
50% Financials
40% Health Care
Consumer Staples
30% Consumer Discretionary
20% Materials
Energy
10%
0%
MSCI EM MSCI EM MSCI EM MSCI USA MSCI Japan MSCI Europe MSCI
Asia Latin America EMEA ex UK United Kingdom
Source: Factset, Barclays. As at December 2018.
Compass Q1 2019 | 19Investment Strategy
Theme #3: European Banks
Overview
• The European economy continues to provide a helpful backdrop for the region’s banks.
• Valuations are not demanding, providing room for re-rating.
• Regulatory and other risks remain, but upside potential remains significant.
Value or value trap?
While the banking sector on the other side of the pond has soared over the past few years, value investors have kept a keen eye
on the continental European banking sector as their shares have suffered. Structural challenges vary across countries within
continental Europe but failure to adapt business models, non-performing loans and negative interest rates are just some of the
common factors which have weighed on banks’ profitability. The recent soggy patch in the continental European economy can
be largely chalked up to the transitory effect of a messy adoption of new auto emissions tests. This will fade as we look at the
12 months ahead and the fundamental outlook for European banks is likely to improve, in our opinion.
Cyclical tailwinds
With structural challenges likely to be resolved only slowly, we are more reliant on Europe’s cyclical upturn to help drive bank
profitability higher. Despite the recent slowdown, we continue to see an increased demand across corporate lending, mortgages
and consumer credit. A robust macro backdrop should continue acting as a tailwind for loan growth – a key driver of bank
profitability (Figure 1). The ECB’s reluctance to raise interest rates has put pressure on net interest margins, but with the central
bank set to hike rates in 2019 this headwind could fade. Meanwhile, banks’ capital positions have significantly improved in recent
years, with the European sector’s core regulatory capital as a proportion of total risk-weighted assets having doubled in the
last decade. On balance, European banks have been moving in the right direction, and their fundamental position has improved
markedly compared to the last several years.
FIGURE 1: Loan growth continues to pick up
14 Adjusted loans to private sector growth year-on-year (%)
12
10
8
6
4
2
0
-2
Eurozone
-4
1998 2001 2004 2007 2010 2013 2016
Source: ECB, Barclays. As at December 2018.
20 | Compass Q1 2019Investment Strategy
Take out
Investors will not need long memories to work out why this
is not an investment for all risk appetites. Notwithstanding
the aforementioned hurdles, the sector remains hostage to
European political uncertainty, with the most recent example
being Italian politics, which seemed to draw attention
away from a marginally improving picture of underlying
fundamentals. Meanwhile, risks of rising trade protectionism
threaten to derail growth momentum, and the cyclical
tailwinds for bank profitability with it. Turkey’s currency crisis
also weighed on sentiment at the end of the year, given fears
regarding some of the bank’s exposure to Turkish assets.
However, the exposures are estimated to be minimal which
has alleviated fears of any systemic solvency risk to the wider
sector. Valuations are currently low relative to history (Figure 2),
thus implying higher upside potential should our base
scenario play out as expected. All in all, the sector remains an
attractively priced, albeit risky, long-term play on European
growth. Nerves of steel and patience are still required, but still
likely to be rewarded in our view.
FIGURE 2: Valuations are low relative to history
100 Trailing PB relative to market (%)
90
80
70
60
50
MSCI Europe ex UK banks
40
Median
30
Jan-95 Jan-00 Jan-05 Jan-10 Jan-15
Source: Factset, Barclays. As at December 2018.
Compass Q1 2019 | 21Investment Strategy
Theme #4: Japanese Equities
Overview
• Genuine changes to corporate governance among Japanese firms are starting to take hold.
• These changes may lead to firms not only generating sustainably higher returns, but also being
rewarded for those higher returns with higher valuations.
• Our bet on improving Japanese corporate profitability is a multi-year theme rooted in micro-foundations
– the changing interaction between managers and shareholders.
Lessons from history
Japanese corporate profitability trends at a lower level than much of the rest of the developed world, particularly the US (Figure 1).
The history of corporate Japan, both pre and post-WW2 is more influential in this story than many realise. Japanese chief
executives and owners have long focused on stability and market share over the traditional American model, where maximum
profitability is the first, and in some eyes, the only responsibility of management. From heavy clustering of AGM’s (making
shareholder challenge more difficult) to a high degree of cross shareholdings (creating a base of eternally friendly shareholders
and contributing to inefficient allocation of capital), inferior Japanese corporate governance in Japan can explain a large proportion
of the shortfall in trend profitability.
FIGURE 1: Corporate governance in Japan has hindered profitability
20 Return on equity (%)
15
10
5 MSCI World
MSCI USA
MSCI Japan
0
-5
2007 2010 2013 2016
Source: Factset, Barclays. As at December 2018.
Is the change real this time?
These long acknowledged hindrances to a higher trend in corporate profitability have proved harder to shift than the analyst
community have repeatedly argued down the years. However, genuine changes are starting to take hold, and are being rewarded
by investors. AGM clustering is declining fast while independent directors are multiplying. Beyond that, there are now increasing
signs that following the new corporate governance code, the stickiest of these inefficient practices, cross-shareholdings, are
starting to decline. The recently implemented revised corporate governance code in principle rejects the practice of cross-
shareholdings and calls for companies to comply with this principle. We have already seen a marked uptick in reduction policies
announced in the reports issued between June and August of this year, just after the implementation of the new corporate
governance code. We would expect this to accelerate as the code becomes embedded.
22 | Compass Q1 2019Investment Strategy
So what?
Superficially, it is hard to see why these changes in corporate
governance would set investor pulses racing. However, for
long suffering investors in Japanese equities, these changes if
they continue to take hold could represent the beginning of
a genuine regime change for investors. One which ends with
Japanese companies not only generating sustainably higher
returns, but also being rewarded for those higher returns with
higher valuations. This is something that investors will want
some exposure to in portfolios if it does indeed proceed as we
are starting to believe.
Alongside this, we think that a Japanese economy currently
emerging from more than two decades of deflation may
provide a helpful tailwind to corporate profitability (Figure
2). The combination of rising inflationary pressure and a
relatively tight labour market implies more upside to wage
gains, which should in turn encourage more capex investment
among Japanese companies in order to reduce labour costs.
The productivity gains from increased capex spend would
be complementary to the above-mentioned benefits from
improved corporate governance. Not only would these
productivity gains translate into greater profitability, better
corporate governance would make it more likely that capex
investment funds will be spent efficiently (i.e. targeting projects
or acquisitions that maximise shareholder value, as opposed
to managerial ‘empire building’). However, we also note that
our bet on improving Japanese corporate profitability is a
multi-year theme rooted in micro-foundations – the changing
interaction between managers and shareholders – rather than
the path of the domestic economy. Therefore, we think it’s
less dependent on us having to undergo the difficult task of
forecasting the multi-year path of the Japanese economy.
FIGURE 2: Two decades of deflation are now behind Japan
4 Percent
3 Japan CPI inflation
Japan core CPI inflation
2
1
0
-1
-2
-3
1996 2001 2006 2011 2016
Source: Datastream, Barclays. As at December 2018.
Compass Q1 2019 | 23Investment Strategy Theme #5: The ‘Fourth Industrial Revolution’ Overview • Mankind is advancing into uncharted territory in materials science, robotics and artificial intelligence (AI) to name just a few of the more high profile areas. • Identifying the winners from such widespread technological advance is a tricky endeavour. • A diversified bet in likely adopters and broader cyclical sectors can be a more effective way to profit. Broad-based disruption As described by the famous engineer and economist, Klaus Schwab, the ‘Fourth Industrial Revolution’ is characterised by a fusion of technologies that are “blurring the lines between physical, digital and biological spheres”. There are few times in history which match up to the current pace of technological advancement, let alone the breadth across different sectors for which this disruption is permeating through. However, we should exhibit a degree of humility when attempting to identify the specific companies which will be at the forefront of this frontier of change. For every Google, there is a Yahoo. Evolving benchmarks A US index of stocks that was once dominated by railroad barons at the end of the 19th century is now governed by technology powerhouses (Figure 1). These companies’ ability to profitably adapt through a variety of political, economical and regulatory regimes is reflected in their remarkable ascent in the indices which represent them. Just as the sector continues to evolve, so do the indices in which they are quoted. A rare reformation of the GICS industry classifications – designed to reflect the evolution in which people communicate and access information/entertainment content – pays testament to the idea that the definition of what constitutes a technology company now is perhaps blurrier than in the past. FIGURE 1: Top 10 stocks in the world by market cap 2010 2018 Exxon Mobil Apple Inc. PetroChina Microsoft Apple Inc. Amazon BHP Billiton Alphabet Microsoft Johnson & Johnson ICBC Facebook Petrobras JPMorgan Chase & Co. China Construction Bank Exxon Mobil Corporation Royal Dutch Shell Nestle Nestle Berkshire Hathaway Source: Factset, Barclays. As at December 2018 24 | Compass Q1 2019
Investment Strategy
A call option on future human
productivity
In our view, the global technology sector represents a type of Nonetheless, more broadly, innovation and its adoption is the
focused call option on future human productivity. Excessive ultimate force that drives corporate profits higher in aggregate
valuations are often touted, but scars from prior tech bubbles – essentially a bet on the inventors of new technology and
likely help fuel this narrative – from our vantage point, the its wider adoption. The stock market indices will adapt to the
sector is attractively priced at the moment. There is also brave new world, and reward the faithful (Figure 2).
significant secular attraction in the global industrial sector,
which should, in whatever shape it evolves into, be one of the FIGURE 2: A diversified call option on future human
primary beneficiaries of these technological advances. For
productivity
example, the increasing use of algorithms that predict machine Index level (1871=100, logarithmic scale)
failure and dial in maintenance needs. Or artificial intelligence 1,000,000
that uses historic data to optimise a plant and adjust to
changing dynamics more quickly than humans could. These 100,000
more structural attractions are happily augmented by more
cyclical appeal in the case of both industrials and technology,
10,000
particularly as we see a sustained trend in investment, despite
some fears of wavering demand within certain pockets of
the sector. 1,000 US Equities Real Total Return
Trendline
100
1871 1891 1911 1931 1951 1971 1991 2011
Source: Shiller, Datastream, Barclays. As at December 2018.
Compass Q1 2019 | 25Investment Strategy
Theme #6: US High Yield
Overview
• We still see investors being rewarded for taking carefully calibrated credit risk.
• Historically, long carry strategies have been demonstrated to generate positive excess returns.
• Credit fundamentals are consistent with default rates remaining subdued for now.
Search for yield
After a multi-decade bull run in interest rates and extraordinary measures taken by central banks to combat the most serious
recession (and financial crisis) in living memory leading to historically low yields, positive real returns within the higher quality
corners of the fixed income complex look difficult to come by. While we are certainly expecting the backdrop to become a little
less friendly for higher quality bonds, provided inflationary forces remain broadly in line with central bank targets, we expect this
normalisation to remain measured relative to past rate rising cycles. In such a context, we still see investors being rewarded for
taking carefully calibrated credit risks (Figure 1).
FIGURE 1: Selected credit risk can still be rewarded
Yield to worst (%)
US high yield 7.4
Euro high yield 4.8
US IG banking 4.2
Euro IG banking 1.1
Global convertibles 1.0
0 2 4 6 8
Source: Factset, Barclays. As at December 2018
Carry – a time-tested strategy
Historically, long carry strategies – that is, being long a higher yielding asset while being short a similar low yielding asset – has
been demonstrated to generate consistent outperformance over time. Should the current credit conditions remain supportive,
we would expect these carry strategies to outperform. With the ISM Manufacturing Index (our preferred lead indicator for the US
business cycle) rebounding after an easing of momentum, we expect growth momentum to persist. Default rates are expected
to further decline after falling throughout 2018 and with lead indicators in the US still inconsistent with an imminent end to the
business cycle, we still view thoughtful exposure to US high yield bonds attractive from a risk/reward perspective.
26 | Compass Q1 2019Investment Strategy
Current fundamentals FIGURE 2: Lending standards continue to ease
100 Net % of respondents reporting tightening
Looking at ratings, we note the credit quality of US high yield in lending conditions
has slowly drifted higher over the past few years. Current 80
lending standards, as measured by the Federal Reserve’s Senior 60
Loan Officer Survey, are showing signs of easing (Figure 2)
40 US C&I loan survey
while the number of bonds trading at “distressed” levels is
near all-time lows – both consistent with expected subdued 20
default rates. Borrower friendly conditions have fuelled a
0
surge in “covenant-lite” debt, which has reduced the overall
level of investor protection across the market. Whilst this is -20
predominantly observed in the loan market, the growth of loan -40
issuance might indicate lower recovery rates for high yield 1999 2002 2005 2008 2011 2014 2017
bonds as the latter typically sits below loans in a company’s Source: Federal Reserve, Datastream, Barclays. As at December 2018.
capital structure. However, our view of the current economic
backdrop and credit fundamentals means we don’t yet see
cause for concern.
Risks
We note that long carry strategies are vulnerable to sharp
near-term drawdowns when wider market conditions turn.
High yield bonds tend to exhibit a higher frequency of ‘fat-
tail’ losses in their return distributions, despite having better
risk-adjusted returns than equities over the long term. Hence,
this particular strategy is only suitable for investors with a high
tolerance for drawdown risk. The other point worth noting
is that due to the asymmetrical risk/return profile of bonds
– particularly when choosing a carry strategy – means that
avoiding the ‘losers’ can reap significant benefits.
Compass Q1 2019 | 27Tactical Asset Allocation
The View from the Asset Allocation Forum
A more appealing defence – Our TAA positioning
We believe the world economy will continue to grow. We are nonetheless on the
lookout for signs of cyclical excess. In such a context we welcome moves towards a
more normal monetary backdrop in the developed world.
Cash & Short-Maturity Bonds: Underweight
• While the economic backdrop appears benign and real interest
rates starkly negative in most jurisdictions, other asset
classes look more attractive to us from a
risk/reward perspective.
• We have recently deployed this asset
class to neutralise some underweight
positions in our portfolio.
Alternative Trading Strategies:
Developed Markets Equities: Overweight Underweight
• The fundamental backdrop for stocks • The current regulatory
remains attractive. We expect continued framework leaves this
robust profits growth from the developed diversifying asset class without
world’s corporate sector. much tactical appeal at the
• Dividend yields alongside plausible estimates of moment.
earnings growth suggest mid-to-late single digit • We currently use this asset
percentage returns for the year ahead are well within reach, even class as an alternative source
if equity valuations do fall a little. of funding.
• Our preferred developed region is Continental Europe. We’ve seen
material improvements in European corporate profitability, with return
on equity rising in both absolute and relative terms. Meanwhile,
both sales growth and net profit margins have also been picking up.
We think these fundamental improvements haven’t been sufficiently
priced in by investors.
• If trade tensions continue to dissipate, we would expect this to be
a positive for European equities too, given the corporate sector’s
sensitivity to emerging markets.
High Yield & Emerging Markets Bonds:
Neutral
• In a world where defaults are expected to
Emerging Markets Equities: Overweight remain contained and inflation more or
• Weakening economic momentum, trade tensions, and pockets of currency less benign, there are carry attractions to
wobbles have all weighed on returns. Nevertheless, the scale of this year’s this asset class.
underperformance suggests that a lot of the bad news has already been • However, we think that scenarios
priced in. where High Yield Bond spreads tighten
• We think that there is scope for a rebound over the next 6-12 months, meaningfully further are becoming
conditional upon our views that trade tensions do not materially escalate increasingly unlikely, especially with
further, and growth stabilises from here on. the increased odds of a trade war, and
• Looking beyond that, we see Emerging Markets Equities as a leveraged bet spreads being so narrow relative to their
on global growth, something we are keen to take advantage of as the global post-crisis average.
growth cycle continues.
• Asia remains our preferred region, with Korea, Taiwan, China (offshore) and
India our favoured bets on a long-term basis.
28 | Compass Q1 2019Tactical Asset Allocation
Here, we explain our current thinking behind our Tactical Asset Allocation (TAA). Please refer to the glossary below for an explanation
of the terminology.
We still see investors being best served by leaning portfolios towards developed equities, and Continental Europe in particular.
This is our view but it’s important to appreciate that predictions of future investment conditions are always uncertain. Outcomes may
differ from those that we expect. Circumstances might change or we could be wrong. We don’t give personal investment advice.
You make your own decisions. If you’re unsure, seek independent personal advice.
We maintain a long-term Strategic Asset Allocation (SAA) for five risk profiles, based on our outlook for each asset class. We also
make tactical adjustments to our portfolio, mainly based on our shorter term (three-to-six month) outlook. Here, we share our latest
thinking on our key tactical exposures.
Real Estate: Neutral
• We continue to regard this asset class as a diversifying asset,
which can provide attractive returns with careful selection and
management.
Investment Grade Bonds: Underweight
• We note that quality in the sector has been
declining and we remain tactically wary due
to the meagre yield on offer from an asset
class that is not without risk.
Developed Government Bonds:
Neutral
• In the very near-term, we think that a lot
of upward pressure on yields has been
priced in. As such we have neutralised our
underweight position.
• Over the medium-term, we expect the asset
class to underperform risk-on assets, and
for yields to trend steadily higher within a
still benign macro-environment.
• Here, we see the asset class offering
diversification rather than return appeal, as
suggested by both our current tactical and
strategic asset allocation.
Commodities: Neutral
• Commodities remain an area of low conviction for us.
• The ongoing slowdown of China’s old economy should provide a stiffer
Glossary headwind to base metal prices.
Strategic Asset Allocation (SAA): the long-term view based on our
outlook for each asset class
Tactical Asset Allocation (TAA): tactical adjustments relative to our
SAA, mainly based on our shorter term (three-to-six month) outlook
Overweight: tactical exposure to a particular asset class which is in
excess of our long-term allocation (SAA)
Underweight: tactical exposure to a particular asset class which is less
than our long-term allocation (SAA)
Compass Q1 2019 | 29Tactical Asset Allocation
FIGURE 1: Tactical asset allocation (TAA) tilts and strategic asset allocation (SAA) benchmark (moderate risk profile)
Expected 10Yr SAA Strong Strong
Underweight Neutral Overweight
Returns* Profile 3 Underweight Overweight
With the economic backdrop still benign and real interest
Cash & Short rates starkly negative in most jurisdictions, the cost
2.3% 9%
Maturity Bonds of holding cash as protection is too great relative to
opportunities elsewhere in our tactical portfolio.
In the very near-term, a lot of upward pressure on yields
Developed
2.1% 8% has been priced in. As such we have neutralised our
Government Bonds underweight position.
Nominal yields in high quality corporate credit remain low
Investment Grade
2.9% 6% in absolute terms. We prefer to venture further out into
Bonds the credit risk spectrum to increase portfolio returns.
In a world where defaults are expected to remain
High Yield & contained and inflation more or less benign, there are
Emerging Markets 5.2% 13% carry attractions to this asset class. However scenarios
where High Yield Bond spreads tighten meaningfully
Bonds further are becoming increasingly unlikely.
Europe-ex UK currently our largest overweight within
Developed
8.1% 35% DM equity allocation. Profits cycle much younger, and
Markets Equities valuations less stretched.
We remain overweight Emerging Markets Equities with
a preference for Emerging Asia. Historically, the region
Emerging Markets
10.5% 9% tends to be highly-levered to the global business cycle,
Equities and we think it is still set to benefit from expanding
trade and healthy global growth.
Neutral on Commodities, as a broad asset class.
Commodities 5.0% 3% However, there are select opportunities within individual
commodity futures that are currently in backwardation.
Property is a heterogeneous asset class, with
different regions and vehicles providing very different
Real Estate 7.8% 4% characteristics. However the simplest way to think of
this asset class is a diversifying asset, which can provide
attractive returns with careful selection and management.
Regulation and lower leverage leave this diversifying asset
Alternative Trading
4.0% 13% class without tactical appeal. ATS used as a source of
Strategies funding to increase exposure to higher beta assets.
*Annualised. Assumes a USD risk-free rate of 2.3%; excludes fees and taxes, not guaranteed, subject to change with each SAA review.
We use qualitative descriptions of our Tactical positions relative to their Strategic benchmarks, ranging from ‘strongly underweight’ to ‘strongly overweight’. This is a shift away from the percentage-
based reporting method we used in the past. Our Strategic Asset Allocation (SAA) models offer a mix of assets that over a full business cycle will, in our view, provide the most desirable mix of return
and risk at a given level of Risk Tolerance. They are reviewed every 12-18 months to reflect new information and our evolving outlook. Our Tactical Asset Allocation (TAA) tilts these SAA views to
reflect our shorter-term cyclical views. Source: Barclays, as at 30 November 2018.
FIGURE 2: Total returns across key asset classes
Cash & Short-Maturity Bonds 1.65%
YTD 30 Nov 2018
Developed Government Bonds 1.23%
Investment Grade Bonds -2.15%
High Yield & Emerging Markets Bonds -3.37%
Developed Markets Equities -1.20%
Emerging Markets Equities -12.24%
Commodities -4.68%
Real Estate -0.07%
Alternative Trading Strategies* -5.05%
*Alternative Trading Strategies YTD to 29 November 2018.
Source: Morningstar, Barclays, as at 30 November 2018. Asset classes in USD and represented by the following indices: Cash & Short Maturity-Bonds, Bloomberg Barclays US Treasury Bills TR USD;
Developed Government Bonds, Bloomberg Barclays Global Treasury TR Hgd USD; Investment Grade Bonds, Bloomberg Barclays Global Agg Corp TR Hdg USD; High Yield and Emerging Markets
Bonds, ICE BoAML US HY Master II Constrnd TR HUSD (40%), JPM EMBI Global Diversified TR USD (30%), JPM GBI-EM Global Diversified TR USD (30%) from 1 August 2016, ICE BoAML US HY
Master II Constrnd TR HUSD (50%), JPM EMBI Global Diversified TR USD (20%), JPM GBI-EM Global Diversified TR USD (30%) from 15 January 2018; Developed Markets Equities, MSCI World NR
USD; Emerging Markets Equities, MSCI EM NR USD; Commodities, Bloomberg Commodity TR USD; Real Estate, FTSE EPRA/NAREIT Developed NR USD; Alternative Trading Strategies (ATS), HFRX
Global Hedge Fund USD. For a table of historical discrete annual performance, please see the Appendix.
Past performance is not a reliable indicator of future returns.
30 | Compass Q1 2019You can also read
