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CIO Insights

Stay prepared

Investment themes and forecasts update
Letter to Investors

Stay prepared

Christian Nolting
Global CIO

There is a risk, in a time of prolonged economic uncertainty, that you become blinded to the pitfalls ahead. U.S./China trade tensions have now been ramping up for over a year, and other geopolitical tensions for even longer (Brexit for over three). But while we have suffered bouts of volatility, markets have not fallen into a more prolonged period of gloom. To a great extent, this has been due to continued efforts of central banks, with the Fed, ECB and Bank of Japan recently loosening policy in anticipation of further economic weakness. As a result, economic growth and financial markets have been supported, even though these are not the primary goals of central banks.

Even though times have changed since the beginning of the year, we still feel comfortable with the six themes that we highlighted in January.

  • 01
    Our first theme “Economy – growth deceleration” has already been borne out by events, with slower growth in most of the world’s major regions and a few individual economies possibly in recession. The key issue now is whether the U.S. economic growth engine will not start to stutter, in the face of trade and other pressures. In The consumer as the last man standing, a recession – in the U.S. or globally – is not an imminent threat. At a more micro level, an immediate issue is whether manufacturing’s woes spread into services, as the consumer catches a cold.
  • 02
    “Capital markets – vigilant on volatility”, our second theme, stays relevant. In 2019 financial markets have not yet had a bout of equity market volatility as severe as in late 2018. But one cannot be ruled out. To the contributing factors of trade and other geopolitics, noted above, must be added the more usual late cycle problems – and a growing realization that markets are far from weaned from central bank support. Remember, too, that the VIX is not the only measure of volatility. Other asset classes could also experience spikes in volatility.
  • 03
    Fixed income must remain a particular concern. Our third theme is “Fixed income – U.S. yields on the return” and, while core government yields have declined much more than expected, our advocacy at the start of the year of a selective approach remains valid. In the continuing hunt for yield – in a world increasingly dominated by negative-yielding debt some fixed income segments (for example some emerging markets debt or high yield) may still appeal.
  • 04
    The current environment also has implications for our fourth theme “Equities – earnings ease”. Actual corporate earnings – and expectations around future profitability – have been easing down, although we think that market estimates for Q4 2019 could still be unrealistically optimistic. So despite continued central bank policy support, we think that equities may provide only modest gains over a 12-month horizon: the “there is no alternative” (TINA) argument for investing in them needs bolstering.
  • 05
    FX issues in a global portfolio can often be under-appreciated. The expectation in our fifth theme “U.S. dollar and oil centre-stage” that the U.S. dollar would not backtrack significantly against the euro has proved broadly correct: the main point now is to what extent trade-related issues will create political headwinds for the greenback. The Japanese yen and Swiss franc could remain reluctant beneficiaries. In the case of oil, recent events have reminded us that uninterrupted supply should not be taken for granted, but demand concerns may provide a longer-term drag on prices.
  • 06
    Our sixth theme “Long-term investment – tech transition” remains very relevant. Reversals in some individual technology stocks should not blind us to tech’s role in the many exciting structural changes in the global economy. Investor interest in ESG – environmental, social and governance-based investment – continues to increase, as do structural changes in the economy that favour sustainable investments. Fiscal spending is returning as a policy issue and this will have implications for the other structural theme that we added in 2019, enhanced infrastructure.

What should an investor do? The answer must be to continue to recalibrate portfolios and stay prepared for any potential issues ahead. We do not expect a global downturn, but greater market volatility is likely and portfolio construction should anticipate this. With equity market gains likely to be small over a 12-month horizon, avoid any excess equity positions and be clear about regional and sector preferences. Within fixed income, remember that core government bonds are not necessarily “safe”: there may however be opportunities elsewhere, for example in investment grade corporate bonds or emerging markets. Pay attention to FX and how it could affect portfolio returns. Portfolio management and construction reviews are key: this is not an environment where you can stand still.

Christian Nolting
Global CIO
Instant Insights
2019 Themes

  • Economic growth deceleration as expected, but no recession.
  • Watch volatility, as yields might remain lower for even longer and equities earnings ease.
  • Continue to recalibrate portfolios: focus on long-term themes.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in September 2019.

Theme 1
Economy – Growth deceleration

The consumer as the last man standing

Central banks stand ready to support economic growth when needed. We do not expect a recession. But keep an eye on consumers: their confidence could be challenged by the impact of negative economic news.

Recession still appears unlikely

Growth deceleration remains the name of the game, not recession. The markets’ unease about U.S. yield curve inversion over the summer mistook a possible harbinger for evidence of a crunch. History tells us that not all yield curve inversions lead to a recession and also that the lag between inversion and contraction tends to be between one and three years. It is also clear that much of the decline in 10-year yields is not the result of changed Fed expectations or expectations around the Fed outlook, but rather the result of rapidly falling expectations of future inflation. The U.S. economy remains strong and has so far demonstrated remarkable resilience to an evolving trade war and associated growth slowdown. This may be due to its diversification and the relatively low share of exports and imports in its GDP. But the continued enthusiasm of the U.S. consumer is also key to the economy’s continued success and this shows few signs of diminishing. We forecast 2.3% U.S. growth in 2019 after 2.9% in 2018 and expect only a slight further slowdown to 2.0% in 2020 (calendar year forecasts).

Manufacturing’s woes could impact consumer sentiment

This will keep the U.S. well ahead of the developed markets pack. Eurozone growth is forecast at 1.2% in 2019 and 1.1% in 2020. The German economy, the region’s “locomotive”, is struggling and its problems may not be that easy to solve. Manufacturing has a large share of German GDP (around 20%, vs. 10% in France) and this is vulnerable to reduced trade demand from China or elsewhere. So far, German manufacturing’s woes have not yet dragged down consumer sentiment, but an increase in unemployment might do this, spreading the pressure from the manufacturing to the services sector. We have already seen the first signs of this development being underway, and although particularly important in Germany, this issue is not unique to it. A weak German economy would have implications for the rest of the Eurozone, possibly already struggling with the impact of Brexit – either negotiated or in a potentially more damaging “no deal” scenario.

Chinese soft landing still expected but other EM problems remain

In the emerging markets (EM), the key question remains China. Stimulus measures continue on multiple fronts – fiscal and monetary. So far, the data suggests that a sharp slowdown has been avoided, although manufacturing purchasing manager indices (PMI) have gone below the 50 threshold. There is more in the Chinese policymakers’ arsenal and we do not expect a hard slowdown, forecasting GDP growth of 6.2% in 2019 after 6.6% in 2018: we expect growth to remain modest (by Chinese standards) in 2020 too, at 6.0%. But here, too, given that exports make up nearly one-fifth of China’s GDP, and that the trade dispute is unlikely to go away soon, the ultimate question remains the willingness of the Chinese consumer to keep spending. In India, economic growth seems to be chugging along reasonably well, aided by rate cuts by the Reserve Bank of India. Elsewhere in the emerging markets, growth pressure may well be policy-related. They are probably not faced with a repeat of the 2013 taper tantrum, where U.S. policy action threatens to dry up liquidity. But a number of historical problems may come home to roost in economies that have dared to challenge the current policy orthodoxy – for example, Argentina. Elsewhere in Latin America, in Brazil economic growth appears to be picking up and interest rates are likely to be reduced. In spite of this, inflation, for the moment, appears dead in the water in almost all global economies, and it is difficult to identify particularly severe asset class bubbles that could cause an imminent upset. At the moment, therefore, a sudden involuntary tightening of monetary policy by central banks looks unlikely: this also supports the case that global growth will decelerate but not collapse.

Figure 1: Manufacturing leads Chinese GDP growth down
Source: DWS, Deutsche Bank AG. Data as of August 2019.
  • Manufacturing growth
  • GDP growth
  • Manufacturing growth
  • GDP growth
Instant Insights
Economy

  • Growth in all major economies slowing, but recession not expected in 2019 or 2020.
  • Consumers’ enthusiasm could be challenged if employment situation worsens.
  • Chinese growth slowdown controllable, but idiosyncratic EM risks remain.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in September 2019.

Theme 2
Capital markets – Vigilant on volatility

Not a time to drop your guard

Geopolitical risks and other factors could prove less important triggers of volatility than central bank policy change and the potential for miscommunication.

The VIX is not the whole story

Volatility – as measured by the VIX (the so-called “fear index”) – hit a recent high at the end of last year before falling back to more historically normal levels in 2019. It has been easing back upwards in recent weeks. Investors pay attention to the VIX because it shows a certain set of market opinions about the future (via the prices for S&P500 index options). This forward-looking approach is currently more popular than the essentially backward-looking value-at-risk (VaR) models favored by many before the 2008 crisis. Currently the VIX index stands at just over 15 points, marginally lower than the 200-day moving average of 16.69, in a sign that volatility remains in check, for now. But the VIX can provide us with only one small snapshot on volatility. It looks only at market expectations within a particular market area (S&P 500 index options). Moreover, it is important to remember that volatility is not just variance. In plain English, we are not just interested in the extent to which market prices move, but also the speed and sharpness of these moves – and, ultimately, their disruptiveness to portfolios and their reversibility. VIX-type measures do not provide insight here.

Multiple potential volatility causes

Volatility may be driven by specific or general factors. It can be linked to geopolitical factors (where we may indulge in speculative forecasts) or it may be linked to policy shifts – for example, a possible scaling back of quantitative easing. These policy shifts can be “macro” or very “micro” – e.g. detailed regulatory change. So some disruptive forces may be identifiable in advance; others will be very new. Among the potential causes of volatility that we see in our current uncertain environment are the trade dispute and disappointments in corporate earnings. But there are also potential specific causes associated with central banks’ pivot towards dovishness and the potential communications mistakes that could to be associated with this. Seen against the background of an unusually extended economic cycle, with growing fears about when the next recession will hit, this seems a recipe for a rebound in volatility (even excluding the potential impact of any “unknown unknowns”).

Prepare portfolios in anticipation

There are multiple ways to prepare portfolios for higher volatility – either in the construction, or in the strategies used. At the underlying strategic asset allocation level, it remains important to distinguish between the relationships we can (with reasonable certainty) predict and those where we can have only a broader level understanding. Individual asset class and index forecasts are accompanied by different levels of forecast volatility (Figure 2 below). Strategies can be chosen to guard against volatility or specific instruments chosen with built-in safeguards. Excess levels of cash are not the answer here: instead, the broad message remains “stay invested, but hedge”, using “hedge” in the broadest sense, and “recalibrate your portfolio” in order to make it more robust.

Figure 2: Asset class and index 12-month forecasts: returns vs. volatility
Source: Deutsche Bank AG. Data as of August 15, 2019 with returns/volatility to end-September 2020.
  • Rates
  • Equities
  • Currencies
  • Commodities
  • Spreads
  • Rates
  • Equities
  • Currencies
  • Commodities
  • Spreads
Instant Insights
Capital markets

  • Relatively low current levels of volatility are unlikely to be sustained.
  • Take a broad view on volatility measures/causes; don’t over-focus on the VIX.
  • There are multiple ways to prepare portfolios. Don’t simply boost cash holdings.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in September 2019.

Theme 3
Fixed Income – (U.S.) yields on the return

As yields drop, the importance of selectivity goes up

As the hunt for yield intensifies again, in developed markets we prefer IG credit to sovereigns and HY and have a constructive view on EM hard currency bonds.

The fixed income market has continued to defy historical trends. In the U.S., 10-year U.S. Treasury yields have fallen by over 118 basis points between the beginning of the year and the end of August, and are currently still nearly 100 bps down YTD, touching the lowest level since July 2016. Many of the developed world’s government bonds are trading at negative yields. The yield on Italian 10-year BTPs has fallen below 1% for the first time in history and very low yields have boosted demand for such esoterica as the Austrian 100-year bond issued two years ago - which has the appeal of a yield of 2.1%, unremarkable at issue but remarkable now. Given widespread expectations for further monetary easing both in the U.S. and possibly even in the Eurozone, this trend is likely to continue. Spreads have been compressed to the point where even the heightened uncertainty surrounding Brexit has failed to cause a spike in gilt yields.

Government bond yield targets are revised down

Generally speaking, geopolitical tensions and expectations of an economic slowdown should support investor interest in government bonds – and thus downwards pressure on yields – even if inflation edges up in the U.S. Our 12-month target for 2-year Treasury yields has been lowered to 1.50%, for 10-year yields to 1.75%, and for the 30-year maturity to 2.10%. In Germany, we see the 2-year Schatz yield at -0.80% at end-September 2020 and the 10-year Bund at -0.50%, while our yield target for the 30-year Bund is 0%. The global hunt for yield is complicating matters for the Bank of Japan, forcing it to allow for temporary deviations from the +/- 10 basis point range of its 10-year bond yield target of 0%. Because there is little scope for the BoJ to cut rates further, we don’t see significant upside potential for Japanese bonds. 2-year Japanese government bond yields are forecast at -0.20% over a 12-month horizon, with 10-year yields at -0.10%.

Corporate debt opportunities continue

The outlook for corporate debt is nuanced, with a number of areas of opportunity. We believe that the monetary stimulus by the ECB should support the European investment grade (IG) market, as does a sheer lack of investment alternatives. The U.S. IG market still looks attractive because of the relatively higher yields, but we see limited potential for further spread compression. We remain constructive on emerging market bonds in hard currency. EM corporates are supported by robust fundamentals such as low leverage and ample liquidity cushions and therefore offer an attractive risk/reward ratio. Many issuers benefit from prudent risk management amid moderate capital expenditure. In fact, the debt levels of Asian IG and HY corporates are at the lowest levels in nearly six years. Inflation remains muted both in Asia and most of Latam, prompting several central banks to start cutting interest rates. For these reasons, we expect EM credit to offer higher returns than can be found in developed markets, namely in the low to mid-single-digits. Across regions, we prefer investment grade credit to HY in spite of low default rates because we believe that the risk premium of HY does not justify the additional risk. In the long term, we also keep a constructive view on sovereign bonds in emerging markets, but the recent escalation in trade tensions represents a downside risk. Asian governments are actively using economic stimulus measures, especially in China, Indonesia and India. In particular, China’s PBoC has recently lowered the Reserve Requirement Ratio and the lending rates for smaller companies, which could be supportive for credit.

Figure 3: Credit metrics may support Asia IG and HY debt
Source: JP Morgan Research, Deutsche Bank AG. Data as of August 28, 2019.
  • Asia IG
  • Asia HY
  • Asia IG
  • Asia HY
Instant Insights
Fixed income

  • In spite of record-low yields, further price increases are possible across the fixed income spectrum.
  • Low default rates in developed and emerging markets should support credit.
  • We keep our constructive view on emerging market hard currency bonds thanks to healthy spread levels vs. developed market bonds.

Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Your capital may be at risk. Readers should refer to disclosures and risk warnings here. Produced in September 2019.

The topsy-turvy world of negative yields

Trillions of euros in government debt now trade at sub-zero yields, including almost all maturities of debt from 1 year to 30 years issued by several major European economies. Overview of government bond issuance with negative yields, country by country:


Figure shows the market value of bonds issued by each government that traded on sub-zero yields on 29 August 2019. Data as of 29 August 2019. Source: Bloomberg, ECB, WSJ/Tullet Prebon and Investing.com
    Positive
    Negative
Shaded area indicates % of bonds trading at negative yields
Germany
€1,580bn
1
2
3
4
5
6
7
8
9
10
15
20
25
30
100%
Netherlands
€308bn
1
2
3
4
5
6
7
8
9
10
15
20
25
30
100%
Finland
€105bn