Clarity in a clouded market

Where should investors be positioning themselves for surprises such as a trade war truce, and what areas of the market look like good opportunities?

Investors are faced with a number of market risks. The most obvious one stems from the US/China trade war, where a short-term ceasefire seems likely but major improvements less likely due to ideological differences and China's political ambitions. We expect slower Chinese growth as the shift from exports to internal consumption continues. UK corporate investments have already slowed ahead of Brexit, creating pent-up demand. However, recovery potential is likely limited as consumers have not been overly cautious. Asset prices could be boosted in the run up to the 2020 US presidential election given Trump's preoccupation with equity market returns. Central banks are expected to remain supportive and short-term interest rates will likely continue falling, supporting equity valuations. We expect downgrades to 2019 earnings and believe current 2020 EPS estimates look ambitious. As stock pickers, we focus on companies where the earnings growth potential is driven by company-specific factors or secular growth, rather than being reliant on cyclical factors that are out of the company's control.

Where should investors be positioning themselves?

Bond investors have become very downbeat about the outlook for growth and inflation in the Eurozone and this is reflected in negative yields in several countries, most importantly Germany. In many ways this is justified given the structural challenges faced by the region, the ECB's recent expansion of QE and unstable US-China relations. However, any improvement in the near term outlook, particularly around a trade deal, would leave Eurozone bonds looking very poor value indeed and subject to a material repricing. Instead the US and China, where real yields are higher, currently offer better opportunities for investors and a more attractive risk/reward trade off.

How should investors position themselves for market surprises, such as Brexit or US election results?

Our experience has been that in a market environment beset by significant event risk, investors are well served by carrying lower amounts of baseline risk while looking to be dynamic, seeking to exploit the inevitable dislocations that arise from the combination of highly consensual investor outlooks and residual event risk. In such an environment, investors should pay particular attention to segments of their portfolio where crowding is prevalent. Such positions are often vulnerable to spontaneous de-risking and sharp reversals when events or newsflow challenge the consensus view.

While the market can often ignore economic data and corporate fundamentals for short periods of time, it will eventually return to these fundamental drivers. Therefore, it is important to focus on our core investment principles while maintaining a healthy respect for the ability of positioning and sentiment to be the primary drivers of performance for extended periods of time.

What areas of the market look like good opportunities?

In 2020, we believe that investors should focus on embedded value-creation and/or property sub-sectors where demand exceeds availability. Such areas include last mile logistics, student housing, research and development facilities, aged care and multifamily, depending on the market. That said, these are also where the greatest competition exists.

Given we do expect only limited capital growth, we also believe this is a market where asset management skills are likely to prove pivotal to returns. In particular, the skill to identify buildings which can be upgraded, reconfigured, re-tenanted, or re-positioned to generate new revenue streams or to enhance rental income can make a material difference. Investors also need to ensure that there is actual demand for that type of asset, particularly as economic growth slows. We also advocate carefully limiting costly portfolio turnover. Finally, it will also be important to avoid simply getting into a competition for yield or pushing up leverage to generate returns.

Where should investors be positioning themselves?

We believe the strategic asset allocation (SAA) decision is the single most important decision that any investor can make. At UBS Asset Management, we develop and update quarterly our five-, 10- and 30-year return expectations for a variety of assets. Read our most recent capital market return expectations here.

SAA relies on historical or modelled relationships which we believe should have a high probability of holding over the medium and long term, but that are more prone to surprises over the short term. The challenge to this approach at the moment is there are few asset classes that are notably cheap. In fact, some asset classes that normally play an important defensive and diversification role are notably expensive. Investors are therefore rightly worried about downside risk from a variety of market attributes.

Understanding near-term risks lends itself to a strategy that tries to be more nimble in allocations. We believe that valuation is the most important driver of asset class return over the long term but we also recognize that it has almost no effect on asset returns over the short term. For this reason, an active tactical asset allocation that takes macroeconomic themes and the positioning of other investors into account may benefit returns and risk management over short horizons.