Investors should start considering how they will prepare portfolios for the end of the bull market, according to asset allocators at Legal & General Investment Management (LGIM), although it is not quite time to turn completely defensive. 
It is more than a decade since the start of the global financial crisis but markets have enjoyed a nine-year bull run thanks to ultra-loose monetary policy and steadily improving economic growth.
FE Analytics shows that the MSCI World index has posted a 216.73 per cent total return (in sterling terms) over the past nine years, driven by the close-to 320 per cent gain in the S&P 500.
In the UK, the FTSE All Share has risen 140.99 per cent while emerging markets – which have had a relatively tough decade – are still up by just over 100 per cent.
Performance of indices over 9yrs
Source: FE Analytics
But despite the strong start to the year, 2018 has seen progress much harder to come by. The S&P 500 has made 13.09 per cent but the FTSE All Share has made just 3.36 per cent while the MSCI Emerging Markets index is down 0.46 per cent.
Emiel van den Heiligenberg, head of asset allocation at LGIM, noted that two opposing forces have pushed markets into “something of a holding pattern” since March 2018: on the one hand, the global economy and corporate profits continue to grow but, on other hand, there has been a rise in populist economic policies.
“We are due to learn soon which one will gain the upper hand,” he added.
Van den Heiligenberg said the short-term risk of recession remains low but he expects global growth to stutter over the long term. LGIM is forecasting that the US goes into recession around 2020 (but will have just gone through its longest post-war expansion) as fiscal stimulus starts to wane and the Federal Reserve continues to tighten monetary policy.
“But other factors are likely to sway asset prices over the coming months, not least the nascent trade war triggered by the Trump administration, the resilience of emerging economies and the evolution of political risk in Europe,” he added.
On the first of these risks – the growing potential for a global trade war – concerns the US imposing tariffs on goods such as steel, aluminium, lumber, solar panels and washing machines, before targeting China with more tariffs and threats to go even further.
LGIM head of economics Tim Drayson said: “Donald Trump says he can win a trade war. It is true that China cannot match the US president’s tariff threats dollar-for- dollar, as it only imports around $150bn of US goods.
“However, the trade deficit vanishes when one considers sales by US companies’ subsidiaries in China, to which Beijing can apply pressure as part of its retaliation. Customs delays, tax audits and increased regulatory scrutiny are possible. China has also proven very effective in the past at whipping up the propaganda machine to encourage boycotts of goods and could even disrupt travel to the US.”
Business interests in other country (2015)
Source: BEA, Macrobond
Drayson added that there is little clarity on whether Trump is using tariffs as a part of negotiations, in which case a compromise between the US and China could be found, or if he has a more strategic goal to push ahead with them in a bid to curb China’s power.
Until this clarity emerges, the economist thinks it is too early to declare ‘peak trade war’ and said the asset management house remains long US inflation, underweight emerging market equities and long the US dollar against Asian currencies in response.
Turning to the second risk and LGIM senior economist Magdalena Polan pointed out that emerging markets have been going through a broad-based sell-off since February this year.
She attributed this weakness to outflows from emerging market funds and some re-pricing in anticipation of higher interest rates in the US and the eurozone.
On an individual country level, the strongest declines have been in a handful of countries such as Argentina, Turkey, Brazil, South Africa and Russia. Polan noted that these countries have weaker fundamentals: wide current account deficits, weaker fiscal positions or higher oil prices adding to already-elevated inflation or trade deficits.
While this does not mean that other emerging markets are “exceptionally strong”, she argued that the indiscriminate sell-off could create sizeable opportunities: “Once investor sentiment stabilises, we believe emerging markets – especially those with better fundamentals and higher expected returns – will offer ample opportunity for profitable investment.”
When considering van den Heiligenberg’s third risk - the evolution of political risk in Europe – LGIM senior European economist Hetal Mehta used Greece as a case study.
Around this time three years ago, Greece had return to the headlines as it appeared to be on the brink of being expelled from the eurozone once more and was having to swallow “yet another bailout”. However, things have improved significantly since then.
The Greek economy is rebounding with growth in 2018’s first quarter rising to 2.3 per cent, sentiment towards the country improving and capital controls being loosened.
“While some of the finer points remain unanswered, it is now very unlikely that Greece would default any time before 2032, in our view – a horizon which largely stretches beyond the attention of markets,” Mehta said.
“In our more active multi-asset funds, we have held Greek sovereign debt since mid-2016. This has been a particularly successful investment so far. In the last few months, the risk-reward trade-off has become more finely balanced, as yields have dropped sharply. However, the broader market implication is that we do not see Greece as a potential source of systemic risk any more.”
Performance of indices over 10yrs
Source: FE Analytics
While these three potential risks appear to have a degree of upside, van den Heiligenberg argued that investors should not expect markets to move upwards forever.
Over the past few years, LGIM has been long risk assets and favoured equities over credit. Given a mid-to-late cycle economy with healthy profits growth, this positioning has worked well.
“It is tempting to start taking profits on this trade, but we believe it is too soon for such a move. Rather, we see the trend as a warning: weakness in credit markets often presages weakness in the real economy,” he concluded.
“Much of the spread-widening is likely due to tightening global liquidity conditions, which will probably exacerbate market volatility in the months and years ahead, as well as impacting business sentiment.
“While we believe it is still too early to turn overly defensive, we are likely nearing the end of the spectacular bull market that started in 2009. We remain alert to the risk of late-cycle asset bubbles as interest rates drift higher, the yield curve flattens and nauseating market gyrations become more commonplace.”