Why Aviva Investors is long US equities, underweight EM

After starting 2019 with a decisively risk-on view in equities, global asset manager Aviva Investors has scaled back its preference for the asset class and taken its overall allocation closer to a neutral position as a result of its lower growth expectations.

This followed Morgan Stanley earlier this week moving from an equal weight to an underweight position on global equities.

Among risk assets, Aviva said it now has a preference for credit, specifically high-yield and emerging markets, and a "modest" preference for Government bonds as an important diversifier.

The US remains Aviva's preferred equity market, balanced by an underweight to emerging markets equities.

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Explaining its move, the manager believes that any early reversal of the recent growth slowdown is unlikely and that inflation pressures will remain weak. In such an environment, returns on risk assets, such as equities, are likely to be more challenged.

Aviva said its outlook for global growth has deteriorated over the past three months largely due to ongoing trade tensions, which have hurt business sentiment, particularly in manufacturing and export sectors.

And even though hostilities between China and the US have eased somewhat following the June G20 meeting, it believes the dispute has not been resolved and could erupt again at any time.

The manager said world growth is likely to slow to around 3% in 2019 and 2020. This is a little below the estimated trend pace, so will further ease any demand strains on capacity limits and prevent inflation rising much, if at all, over the next few years.

And while it believes that recession will be avoided for now, Aviva thinks the major risks – such as trade policy – are to the downside.

Aviva said the combination of slower growth and muted inflation pressure means that major central banks have, rightly, adopted an easing bias. And while the looser monetary policy stance will provide some support, it expects growth worries to weigh on risk asset returns.

This, therefore, justifies its relatively cautious stance on asset allocation.

"Growth concerns mean downside risk for equity returns. As a house, our current equity allocation is neutral, favouring the US over emerging markets. We expect recession to be avoided, so a nasty default cycle is unlikely, and as a result, credit should perform reasonably well," Michael Grady, Head of Investment Strategy and Chief Economist at Aviva Investors, said in a statement.

"More dovish central bank action will help boost duration where we have a modest overweight, while the overall environment should be supportive for carry strategies. We expect the dollar to remain reasonably well supported."

"Deeper-rooted" conflict

In its quarterly House View forecast, Aviva Investors said the downside risk from a trade dispute escalation between the US and China delaying the growth recovery further has risen and, in the manager's view, is not being "fully appreciated by markets".

Aviva said the probability-weighted outlook for equity risk has turned less favourable. This is because global equities have returned to close to their record highs at a time when earnings growth is meagre, and when the multiple is already reflecting a discount rate that incorporates a cumulative 100bps expected rate cut in the US by end-2020.

Aviva thinks the trade standoff between the US and China will prove to be a "deeper-rooted conflict" than first assumed, and incorporating its outlook for slowing global growth into its assessment for the asset class, it noted that, historically, periods during which global growth fell below 3 per cent in year-on-year terms were associated with negative earnings growth 80 per cent of the time (since the late 1990s).

"Our central expectation for global growth is for a stabilization at, or just below, 3 per cent. As we don’t anticipate a deterioration in growth beyond these levels, and therefore see the global economy escaping recession, a prolonged period of negative earnings growth might be circumvented," the manager said.

"However, given the comparably high expectations built in for earnings growth in 2020, we do envision chances for disappointment relative to actual earnings delivery to be meaningful."

US earnings to outperform EM

China’s efforts to stabilise growth remain critical for both commodities and the global economy, according to Aviva Investors.

Beijing’s credit tightening of 2018 has been reversed, income tax cuts are supporting retail sales, and PMIs rebounded in Q1 before easing back a bit in Q2. However, with the US/China trade conflict persisting and broadening to other countries, Aviva said confidence has again been rattled and industry is still slowing.

"Having realised the benefits of better liquidity conditions in the G10, and with less spillover outside China compared with past infrastructure and property booms, we have shifted to an underweight view on emerging market (EM) equities," the manager said.

"The underweight is offset by an overweight view on US equities, with US earnings expected to continue to outperform EM. A positive earnings growth differential in favour of the US has historically most often led to positive performance of such trade."

Risks to current positioning

Though its asset allocation is conservative overall, Aviva noted that there are still important risks to consider.

"Should the Fed not deliver on rate cuts that it signalled are likely in the June FOMC meeting, global yields could reprice meaningfully, even in the absence of hikes," it said.

"Moreover, if a lasting trade détente is reached with China, and EU auto tariffs and 'No Deal' Brexit are avoided, we could see pent-up demand and investment accelerate, lifting inflation and growth, with yields and risk assets in their wake.

"A relatively defensive portfolio would then suffer a mix of opportunity cost (from being close to neutral overall) and some losses (EM underweight and duration), even as US equities and global HY and EM would make gains.

"On the downside, should growth deteriorate, and trade wars become damaging and disruptive, long duration positions may only partially protect losses in credit markets and global equities."