US high-yield bonds and US equities are the most attractive asset classes in the face of continued deleveraging and low interest rates in the West, and slower growth in emerging markets.
James McDonald, senior vice-president and chief investment strategist at Northern Trust in Chicago, yesterday told the audience at AsianInvestor’s seventh annual Asian Investment Summit in Hong Kong that the US was “the fastest tortoise in the race” among developed countries.
The US, Japan and Western Europe remain dependent upon emerging markets for global growth. But McDonald argues the US stock market is a better way to get emerging-market exposure, noting that 40% of revenues among companies in the S&P 500 index come from there.
Moreover, the performance of the S&P 500 is more highly correlated with global economic growth than just with US growth, he says.
However, it is in fixed income where investors need to move furthest from traditional G3 exposures. The lack of liquidity in emerging bond markets means the risk-return profile of emerging-market debt is not so attractive.
Instead, investors looking to reduce reliance upon G3 sovereign bonds should turn to high-grade corporate bonds as a substitute, and to US high-yield to provide the necessary performance to meet return targets.
McDonald notes that whereas three years ago the top ‘safe haven’ names were sovereigns (US and France), today they are corporations: ExxonMobile and Nestlé. These companies can shift manufacturing to countries with favourable tax and regulatory environments, and can readjust entitlements (such as pension promises) more easily than governments. These factors bolster their appeal as safe bets to meet obligations to bondholders.
High-yield, meanwhile, provides equity-like returns and better liquidity than hedge funds or private equity. Allocating to junk bonds assumes US corporate profitability remains strong, and a diversified portfolio can offset the risk of company defaults should the economy falter.
McDonald says the past five examples of such losses in US high yield were temporary: investors were able to break even within a year’s time. The exception was 2007-08, when it took 27 months to return to breakeven levels. So he believes even if spreads are expensive, investors bear relatively less risk in high-yield than in equities, for example.
Northern Trust’s base case is to be neutral equities, but within stocks, overweight the US and underweight Europe and Japan. It is underweight fixed income, but within the category, it is overweight high yield. It is overweight real estate as an inflation hedge. It is neutral towards commodities, but within that bucket, tactically overweight gold, also as a hedge.