The good news is that risk asset classes are in an equilibrium of sorts. The market odds have compressed materially since the February lows, but long horizon investors are still being paid to take equity risk.
Yet from here, the reality is that overall total returns are set to be low – in the order of 5-6 per cent before inflation for global equities, rather than the 6+ per cent after inflation we have gotten used to in the past. But at least equities offer a decent carry versus safety asset classes.
The problem, however, is that the economic environment remains challenging and perceptions of risk are febrile. Growth risks, even phantom recessions, can create substantially volatility in financial markets, as we have seen in Q1 – even if these worries are later revealed to be noise. Low sustainable returns and bouts of episodic volatility are a challenging mix for investors.
That said, the broad environment remains reasonably supportive for equities, especially outside of the US. The global growth outlook is lacklustre, but there is no recession. Moreover, the spill-over from the sectoral recession in energy has been limited so far.
The outlook for so-called safety assets looks more dangerous however. Indeed, there are no safety assets.
Core bond yields are incredibly low versus history. Of course, government bonds are the natural beneficiaries of negative interest rates. But it is a concern that just as a significant amount of bond-bullish news is reflected in today’s pricing, the structure of US inflation is beginning to rise. It could be much better to focus on lower duration plays, including High Yield credit.
Emerging market bonds have fared strongly year-to-date. A reminder that the definition of safety asset in today’s environment must be flexible. It makes sense to nuance enthusiasm for the asset class after rapid strong performance, but allocating to local EM debt can still make sense for long-term investors. Prospective returns continue to look relatively strong, many EM currencies remain unloved, and an active, selective approach should add value.
The market environment has moved quickly from fearing a “secular stagnation” in January and February to discounting lacklustre growth in March. What happens next? Who knows.
But, given the backdrop, it wouldn’t really be a surprise if perceptions of a “stronger recovery” began to emerge, especially in the US.
Joseph Little is chief strategist at HSBC Global Asset Management
