The Federal Reserve has pulled off a monetary policy U-turn since the severe stock market correction late last year. Investors have moved from pricing in two or three rate hikes this year to no change, and there is now even talk of a rate cut. The Fed has also promised to halt its balance sheet reduction programme, which had been on autopilot. There are more and more signs of slowing activity, with the consensus forecast for world GDP growth dropping 0.2 point to 3% with the possibility of more revisions to come. The US economy still appears to be robust, but the Fed has had to revise its own forecasts down. A Chinese slowdown is not reflected in these forecasts, but its annual car sales have just dipped from 30 million to 23 million. Europe is subject to heavy revisions of its own, especially given the threat of Brexit. The German yield curve has become even more inverted, stoking fears of recession. The ECB has been more vigorous and the German 30-year yield is down to an historically low 0.67%. This raises the question: what ammunition is left to the authorities if recession materialises?
One of the consequences of this environment is investors’ renewed interest in real estate. Yields in the sector have dropped to 3% for prime office space in Paris and by more in growth markets such as the USA, and Eastern and Southern Europe. Returns on residential property are running at around 2-2.5%, to which inflation should be added. The easy money of the post-crisis years ended up with the already solvent rich and worsened inequalities. It also enabled American firms to buy up their own shares, at an annual rate that hit a new high of 4.2% in Q4 2018. This has optimised earnings per share and bolstered share prices.
The deal of the moment is the euro/dollar carry trade, which is currently banking 3% over a year if the parity between the two currencies stays put and more than that if the dollar appreciates. It is worth an additional 1.8% if euro cash is invested through the trade in investment-grade corporate bonds. This is certainly a speculative investment if abused, but perfectly sound if it is used to obtain a desired level of dollar exposure in a large private portfolio.
The third type of investment is in equities, which can never be left out, with adjustments to marginal exposure as a function of risk. The S&P 500’s earnings yield is 5.8%; Europe’s is 7.3%. Equity markets are historically more profitable than bonds, but of course they are exposed to the economic cycle. Many investors stayed away from equities after the financial crisis, which halved share prices. Our risk premium valuations give us an end-2019 objective for the S&P 500 of 2,833 points compared with last Friday’s close at 2,834 points. This suggests that Wall Street is fair value, and we believe the background risk to be high, given that profits are at a cycle high. We are therefore slightly underweight our benchmark. For HNWI portfolios worth more than €10 million, our asset allocation is 48% in real estate, 34% in equities, 8% in 2-4 year Treasuries, 5% in other bonds and 5% in cash. The larger the portfolio, the more diversification there is within each segment, for example through office premises, hotels, mezzanine loans, private equity and carry trades.
Despite the economic slowdown visible across much of the globe, equities have been one of the best performing investments so far this year. The MSCI World is up 12.8%, which largely makes up for losses last year. Lower interest rates are the prime reason for this move, and our asset allocation has benefited from it. But readers should remain aware of the risks, including Brexit. We have left that one alone in this edition, except to remark that the markets stopped reacting to it a long time ago. Could they be right about that ?
