Defensive diversifiers to cope with uncertainties
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|ETF Investment Strategist|
The global economy is transitioning out of a deflationary and low growth environment into a state of synchronised economic growth and gradual reduction of monetary easing, with developed economies leading the way.
The International Monetary Fund (IMF) forecasts that the global economy is to rise by 3.9% in 2018, up from 3.6% in 2017. However, we foresee two major downside risks to this outlook, namely inflation and trade war threats, with the latter aggravating the former.
Short-term support, long-term vulnerability
The recent political developments, in the US in particular, point towards a gradual rotation from monetary to fiscal policy to stimulate growth in advanced economies. However, a policy-fuelled economic growth is a double-edged sword. While governmental stimuli support growth in the short-term, their pro-cyclical nature may create economic distortions and increase financial vulnerabilities in the longer-term, especially when introduced at a mature stage of the business cycle. Furthermore, the risk of ‘overheating’ is heightened as most economies are already at or close to their potential.
In turn, a quicker-than-anticipated increase of interest rates will put sudden upward pressure on borrowers, with potentially negative outcomes for companies at the bottom of the credit quality ladder. The President of the Atlanta Federal Reserve and Federal Open Market Committee (FOMC) voter in 2018, Raphael Bostic, recently warned that the “Fed could soon face rising chances that the economy grows faster than forecast and leads to a slightly faster pace of rate rises”.
A shift in policy-maker rhetoric
The increasing global economic momentum has started to reverse the balance of power between cyclical inflation and structural deflation, as suggested by a recent uptick in various inflation measures. A rebound in headline inflation partly results from a pick-up in commodity prices led by stronger global demand, the expectation of protectionist policies leading to higher tariffs on imports and increasing the overall costs of the international supply chain, as well as the anticipation of pro-cyclical economic policies. In light of the recent inflation revival and accelerating growth, the FOMC discussed revising its mandate statement to “monetary policy eventually would likely gradually move from an accommodative stance to being a neutral or restraining factor for economic activity,” according to March meeting minutes.
Populism and protectionism – a long-term challenge
In our view, a common tie that binds the rise of populist political parties in Europe, the UK’s referendum on European Union membership, and US President Trump’s trade war threats, is the rise of inequalities and a belief that globalisation is unfair and responsible for the declining-trend in labour force participation in developed countries. However, inequalities cannot be reversed overnight and protectionism may even exacerbate them. Therefore, we anticipate that populism is likely to be a lasting challenge for the Western countries with short and longer-term economic consequences.
Empirical and theoretical analysis suggest that protectionism is inflationary and may lead to global trade shocks that have larger potential recessionary effects - lowering income and investment - when interest rates are at the zero lower bound. Moreover, trade war threats have increased tensions in an already fragile geopolitical landscape. From an investor standpoint, trade war threats may dampen business confidence and delay investments, lowering the overall earnings outlook, whilst also driving market volatility higher.
 A. Barattieri, M. Cacciatore and F. Ghironi, “Protectionism and the Business Cycle” (January 2018).
A maturing global business cycle
Corporate earnings growth is expected to slow across the board in 2018, with the exception of the US, where the tax relief has boosted earnings forecasts. The decline in earnings growth forecasts echoes the recent slowdown in activity indicators. With the exception of the US, composite PMIs are declining while remaining well above the expansion threshold of 50. This could be an indication that the global business cycle is maturing. We believe European, UK and emerging market equities offer an attractive discount to US equities. Although, pro-cyclical fiscal policies in the US could extend the current economic cycle and support earning growth as domestic demand rises.
Investment strategy: prefer defensive diversifiers
Synchronised global growth along with subdued inflationary pressures continue to provide a positive environment for equities and bonds. However, the revived inflationary threats and the possibility of higher interest rates could erode corporate profitability and lead to further bursts of volatility. In this environment, we favour investment strategies that allow investors to cautiously participate in market upside, either by selecting quality assets or managing portfolios to enhance yield and limit interest rate risk.
Benefiting from higher implied volatility
The rise of expected volatility results in a higher premium for investors selling call options on their equity holdings, namely implementing covered call, sometimes called ‘buy-write’, strategies. In our covered call strategies included in the BMO Enhanced Income Equity ETFs, we have increased the mid-term option yield target from 2 to 3% per annum across all regions – UK, US and Europe. What’s more, the current outlook of stable to slightly rising equity markets is positive for our covered call strategies as investors can benefit from positive market performance while also receiving an additional premium from selling index call options against 50% of the portfolio. Typically, steadily rising markets allow our ETF portfolio managers to gradually adjust the ‘moneyness’ of the call options to minimise the risk of the options being exercised while allowing upside participation.
Overall, we expect to enhance the current net dividend yield of 4.4% for the FTSE 100 Index, 3.1% for the Euro Stoxx 50 Index and 1.6% for the S&P 500 index (as at 29 March 2018), by 3% per annum over the medium-term, to a total estimated annualised portfolio yield of 7.4% in the UK, 6.1% in Europe and 4.6% in the US. Read our February note for more.
Avoiding the ‘yield trap’
Fundamental screening of higher-yielding companies reduced the risk of falling into a yield trap, while also reducing volatility and still capturing decent yield. Investors can benefit from the combination of quality and dividend yield factors through a systematic investment style to capture the excess returns of high-quality stocks over low-quality stocks. Quality companies are less vulnerable to rising interest rates as they usually exhibit low leverage, superior profitability (a company’s ability to generate earnings as compared to its expenses) and lower earnings variability, which suggests they are aptly managed and can quickly adapt to economic changes. BMO Income Leaders ETFs track the MSCI Select Quality Yield Index, which selects the most robust companies according to these three aforementioned fundamental criteria before screening for the top 50% of them according to their dividend yield. Read our March note for more.
Duration management using bond ETFs
As the yield gap between dividend yield and bond yield collapses, we expect a gradual rotation from equity to fixed income investments. We believe global corporate bonds are likely to benefit from the improving global economic backdrop, while US corporates will also benefit from the Tax reform.
However, the rising interest rate environment is particularly challenging for fixed income investors, as bond prices move inversely to interest rates. BMO 1-3 year Global Corporate Bond ETF is one option for conservative short-duration fixed income exposure. For longer-term investors, looking for income and diversification, BMO Global Corporate Bond ETFs offer different maturity buckets (1-3yr, 3-7yr, 7-10yr) which are useful tools for implementing a range of interest rate immunisation strategies, without involving a complicated set of calculations. In addition, to be cost-effective, bond ETFs also provide an extra layer of liquidity allowing investors to quickly adapt to the changing economic environment. Read our January note for more.
 Target portfolio option overlay coverage varies between 40 to 60%, and represents 50% on average.
 The relative position of the current price of the equity index with respect to the strike price of the call option.