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Disappointing economic data and growing geopolitical tensions have made investors nervous. The 10-year German government bond yield keeps setting new record lows, recently dropping below -0.7%. Asian currencies are falling versus the US dollar and the copper price is on the verge of a further breakdown. Moreover, European banks seem extremely vulnerable, with Deutsche Bank’s share price reaching an all-time-low yet again.
With Germany’s economy contracting in the second quarter of 2019 and China’s factory output disappointing, signals increasingly point to a global economic slowdown. So far, however, the slowdown seems contained to the manufacturing sector. To keep the service sector from following suit, monetary and fiscal stimulus will be needed. Clearly, the market expects a lot from central banks: the ECB, for example, is expected to decrease its policy rate to -0.8% within one year. We do not expect central banks to disappoint, but fear that governments do not yet appreciate the urgency of the matter.
Although prudence is warranted, equities continue to play an important role in portfolios. There is still some potential for positive surprises as the US and China may come closer to a deal. In the short term, US exposure is preferred within equities as large cap earnings growth is still positive and companies continue to buy back their stocks. European equities still have potential if overly regulated sectors, such as banks, are avoided. These sectors may seem cheap according to traditional valuation multiples, but are so for a reason, as poor growth prospects fully account for cheap valuations. Japanese and emerging market equities are clear laggards and there are no indications this trend will change anytime soon.
Within fixed income, we prefer government bonds over corporate bonds. It is key to maintain a global universe within this segment. Global government bonds offer better diversification in a balanced portfolio and higher expected returns than EMU government bonds. Rate curves in Australia, New Zealand, Canada and the US are interesting not only because of their higher yields, but also because of their potential to decrease further. We consider it a real possibility that these countries’ 10-year government bond yields will move towards 0% in the next recession, potentially resulting in double digits returns. We are more cautious regarding corporate bonds due to their low liquidity. Given the prolonged business cycle, protecting a balanced portfolio’s liquidity is imperative. The limited premium offered by corporate bonds and the potential upside resulting from another round of QE do not adequately compensate for the asset class’ lack of liquidity.
Finally, after years of lacklustre returns, the stars finally aligned for gold to outperform again. As more and more bonds offer negative yields, gold has become a more attractive investment. Furthermore, most countries are pushing for a weaker currency, which is typically supportive for real assets. Finally, rising fiscal deficits negatively impact investors’ confidence in the economy, leading to higher demand for safe havens such as gold. Not surprisingly, the gold price has already increased by more than 17% in 2019 with a lot of potential to rise further. Gold’s high return potential and diversification effect makes it a valuable addition to a balanced portfolio.
In conclusion, we expect a portfolio consisting of large cap equities (mainly in the US and Europe), international government bonds and a position in physical gold to cope well in an environment of increased volatility.