As we move into the latter part of 2016, investors often ask how they should be positioned. We address this inquiry by walking through the three distinct questions that our investment process seeks to answer.
First, does the economic environment support taking risk?
Today, we are seeing a cyclical divergence across developed and emerging markets. Most emerging markets are in the “recovery” phase of our business cycle framework, while major developed markets have moved past the peak of their cycle and are currently in a “slowdown” phase, per Exhibit 1. This divergence leads us to favour cyclical opportunities in the emerging markets across many assets.
Second, what is the level of risk across asset classes?
Volatility in the U.S. has come down significantly since the start of the year, which is a positive signal for riskier assets. However, with rising correlations across stocks and bonds, we are moderately concerned that traditional diversification measures are waning. In such an environment, we pay particular attention to downside mitigation, especially when insurance via option-based strategies is relatively inexpensive. In the emerging markets we see the stabilisation in commodities and improving risk appetite as favourable tailwinds.
Third, how well compensated are you to take risk?
Valuations are above average across most major asset classes. Therefore, we continue to emphasise relative value opportunities over large directional positions. For example, emerging markets exhibit cheaper valuations in assets and currencies relative to developed markets. In particular, emerging market local fixed income is attractive with a nominal yield of more than 6% and real yields around 2.4%, per Exhibit 2. We see value in this asset in comparison to developed market bonds that have low or negative real yields. In addition, many emerging markets have room to cut rates as inflation declines. In credit assets we find opportunities in loans, which currently combine attractive valuation, a step-up in credit quality, and less interest rate and sector risk than high-yield bonds.
To that end, our positioning is as follows:
Underweight equities with a preference for emerging over developed equities
- Cyclical divergence and relative valuation lead us to favour emerging over developed equities.
- In emerging markets we are seeing stabilisation, an improved commodity outlook, and capital inflows that mitigate some downside risk.
Within developed markets we favour U.S. over European equities
- Amidst soft global growth, with both Europe and the U.S. slowing down, we favour U.S. equities given their “low beta” nature and lower volatility.
- European equities have much higher beta to global growth due to higher leverage ratios and stronger trade linkages, especially in an environment of sluggish global trade.
Overweight income assets
- Lower volatility coupled with a dovish Fed make for a favourable environment for income assets.
- We maintain broad exposure to income assets with a preference for loans and emerging market local fixed income. Within the U.S., we favour credit over equities given the advanced stage of the business cycle and lower volatility. With sluggish earnings growth, we don’t expect meaningful equity upside.
Neutral U.S. dollar with a preference for emerging over developed currencies
- Again, cyclical divergence and relative valuation lead us to favour emerging over developed currencies.
- The lower volatility environment favours carry strategies with a preference for higher yielding currencies over their lower yielding counterparts.
The J.P. Morgan Government Bond Emerging Market Local Index is a comprehensive, global local Emerging Markets Index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds to which international investors can gain exposure.
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall. Foreign investments may be volatile and involve additional expenses and special risks including currency fluctuations, foreign taxes and political and economic uncertainties. Emerging and developing market investments may be especially volatile.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.