“Keep calm and carry on” had been the outcome of our March market update and asset allocation review. We believed that the slow removal of monetary policy stimulus was more than offset by stable economic growth and rising profits across the globe. The challenges appeared to be more thematic – a faster policy response – than idiosyncratic.

Our June investment committee meeting addressed concerns that markets are now signalling a more active response to some of the extraordinary developments, particularly in Europe and Emerging Markets (EM). This has led to an improved environment for US Dollar assets, with a further rise in the Fed Funds rate to 1.75-2.00% this month, which has so far failed to upset the momentum.

The impact on returns in Q2 has been noticeable. While overall returns from global equities have been positive, EM equities are negative year-to-date. In debt markets, nominal returns from developed market bonds have been negligible while EM debt has underperformed. Meanwhile, the US Dollar has performed well.

With these results in mind, we revisited our preferred measure of credit conditions below to gauge how far policy remains accommodative or restrictive. The chart below measures observed real rates versus the natural rate of interest (i.e. the rate at which the economy neither overheats nor slows down).

 

US Bond Yields

Source: Macrobond, Federal Reserve Bank of New York, Federal Reserve Bank of San Francisco, BEA, Sandaire

 

Although conditions have tightened, it is notable that in 2018, not a lot has changed. We have highlighted before how important negative real rates are for risk appetite, so while a rising rate in 2017 kept us neutral on equites, this year’s moves do not appear to suggest that we need be any more negative.

If, however, we look at the performance of EM bonds, a conscious uncoupling has occurred. Having been resistant to Fed tightening until now, EM bond returns have fallen during April and May.

 

US 10-Year Yields and EM Debt Returns

Source: Macrobond and Sandaire

 

We think the reasons for this are as much to do with EM countries themselves, as it is to do with US interest rates or a rising US Dollar. Currencies such as the Turkish Lira and the Argentinian Peso are weakening due to policy concerns. In Brazil, workers’ strikes and the uncertainty of an October election have affected asset prices. With rising idiosyncratic risk and more central banks in EMs raising rates rather than lowering them, we have reverted to a neutral view on EM debt, both local and hard currency bonds.

In Europe, idiosyncratic risk is most recently apparent in Italy. Our view has been to regard Italian excess and flat growth as old stories and to focus on European Central Bank (ECB) policy and support mechanisms for banks and sovereigns. The ECB has signalled its intent to end bond purchases although it remains accommodative on interest rates. This should provide some relief for investors but of greater concern to our investment team has been the slowdown in fundamentals across Europe. As the chart below highlights, manufacturing activity in Italy, Germany and France stalled in 2018 after a strong pick-up in 2017.

 

Business Survey Data for Italy, Germany and France

Source: Macrobond, IHS Markit and Sandaire

 

It is unclear whether domestic politics (China or trade) are the causes. We gave careful consideration as to whether this warranted a downgrade to our neutral weighting in European equities but given the lack of change in our Liquidity Preference Model, we decided to maintain our neutral stance.

Despite high valuations, the US equity market has continued to perform, helped by stronger than expected earnings. There is little to dissuade us from maintaining a neutral weighting. Fundamentals are strong and the tail effects of the recent fiscal stimulus remain in place. An interesting measure of value, illustrated below, shows the real effective risk premium on US equites which has been declining over the last three years. During the same period, technology stocks have been a significant contributor to US returns, demonstrating how important compositional changes in US markets have been. On a relative basis, the US market continues to trade at a premium to the rest of the world and has outperformed. In the absence of any substantive reason to believe that a recession is imminent, it would be imprudent to reduce exposure to that market.

 

Real Equity Risk Premia in Developed Markets 

Source: Macrobond and Sandaire

 

For our EM equity exposure, we have been disinclined to remove our overweight. There is little doubt that credit growth has slowed. Trade tariffs, whilst difficult to price, are undoubtedly depressing asset prices and the reversion from a weaker USD in 2017 to a stronger one in 2018 has reduced momentum in EM equites. However, our exposure to EMs largely avoids the countries with the greatest sensitivity to the US Dollar and those with higher external debt burdens. If we correctly predict that the growth momentum in Asia-Pacific EM countries remains in place, then EMs may outperform again.

In the UK, there is little fundamental change in growth expectations and we maintain our negative bias to UK assets, namely bonds and equities. Japanese growth has shown some signs of weakness after a strong 2017, but both the Bank of Japan and the government (post domestic scandals) have maintained a supportive policy stance. This should continue to benefit corporate profit growth particularly given modest forward earnings guidance. We retain our overweight positioning to Japan.

With regards to currencies, we observe that a stronger US Dollar tends to do well when growth is unsynchronised. We do not generally hedge our overseas equity exposure, so if we do encounter a strong Dollar this year, absolute returns will be supported compared to that for domestic assets. Brexit and rising political risk premia will make it difficult for Sterling to rally, especially as weak nominal growth and wage growth limit the Bank of England’s policy response.