Markets are off to a strong start in 2019. A slowing, but growing global economy and patient policymakers—two of the three key investment themes we detail in our new Global investment outlook for the second quarter—are supportive of risk assets. A reduction in perceived geopolitical risk—primarily around U.S.-China trade tensions—has also buoyed market sentiment.
Yet we see a repeat of the first-quarter rally as unlikely, given a narrower path for risk assets to move higher. Risks that could knock markets off track include a resurgence of recession fears; inflation pressures that force the Federal Reserve to resume tightening; or a geopolitical shock—such as a U.S.-Europe trade showdown.
Against this backdrop, we remain moderately risk-on but advocate more carefully balancing risk and reward in portfolios. How should investors consider doing that? We share three investing ideas for the second quarter below.
1. Retain a modest preference for stocks.
What’s behind our conviction, albeit tempered, in equities? Equities have historically performed well in late-cycle periods. Market sentiment and investor positioning in global equities are far from euphoric. And the recent decline in bond yields—if sustained—makes equity valuations look more reasonable to us. We also see factors that could propel stocks further, such as signs that Chinese policy stimulus is translating into higher consumption and economic activity. The nuance: Investors might consider re-balancing, taking advantage of rallies to lock in profits in some of the strongest performers year-to-date.
We see the combination of weaker earnings revisions, higher prices and low volatility, as shown in the Unsustainable momentum chart below, as unlikely to hold. Ten years after the start of the equity bull market, investors are taking risk chips off the table amid growth, policy and earnings uncertainty. These risks are real — yet we retain our preference for equities. Stocks remain our favored asset class in a diversified portfolio.
2. Be selective when taking risk in stocks.
We advocate selective risk taking in areas such as U.S. and emerging market (EM) equities. Our U.S. overweight holds, though valuations are less compelling than at the start of 2019. The U.S. is home to many quality firms—those boasting strong balance sheets and cash flow, and quality remains a key theme for us amid uncertainty. Our preference for EM equities reflects solid earnings, stimulus in China, improving liquidity, and greater China A-shares inclusion in the MSCI EM Index.
Chinese stocks have room to go, in our view, but less upside after a brisk rally. Low expectations in Europe mean it wouldn’t take much good news to nudge stocks higher, but we see little catalyst for a sustained uptrend. We also favor quality equities in sectors that can sustain earnings growth in a slowing economy, such as selected health care and tech firms.
3. Consider U.S. Treasuries as portfolio shock absorbers.
We are cautious on U.S. Treasury valuations after the recent rally, but still see U.S. government bonds as important portfolio diversifiers and resilience sources. Price appreciation has made up roughly three-quarters of U.S. Treasury returns this year-to-date, we estimate, as yields have fallen. Yet we see income reasserting itself as the key driver of bond market returns in the quarters ahead. Coupon income historically has contributed the lion’s share of total returns across global fixed income markets. See the Income is king chart below.
The traditional inverse relationship between U.S. equity and government bond returns is alive and well. We see the negative correlation being sustained in this late-cycle period, with Treasuries acting as a buffer to any selloffs in risk assets driven by growth scares. We expect a gradual steepening of the yield curve, driven by still-solid U.S. growth, a Fed willing to tolerate inflation overshoots — and a potential shift in the Fed’s balance sheet toward shorter-term maturities. This supports two- to five-year maturities and inflation-protected securities.
The path of least resistance for risk assets may be higher in the short term. Yet we advocate more carefully balancing risk and reward. Our preferred approach to building portfolio resilience: ample allocations to government bonds, flanked by selective risk-taking in equities.