Our latest asset allocation meeting highlighted a divergence in the speed of growth within the global economy – developing economies and Europe are showing improved momentum and the US and UK are decelerating. The broad support to growth from higher commodity prices may be showing some signs of slowing down, but this does not suggest to us that overall activity is declining. In the US, consumer confidence remains high, the labour market is tight, and despite the fact that the US Federal Reserve has raised interest rates for the second time this year, credit conditions are favourable.
US Consumer Confidence
Last Reported: April 2017
However, inflation in developed markets appears to be slowing. Expected wage inflation has not materialised and oil price effects have moderated. Although central banks are likely to overlook this when setting policy, the bond market is of greater concern. 10-year yields are lower this year than last year despite stronger growth and inflation data.
Our view is that while yields have not risen this year, this does not signal a negative outcome for the global economy. In fact, this continues to support a positive refinancing environment for companies and the consumer. When we review corporate earnings, we can see that profit growth remains vital to demand for equities, despite high valuations.
MSCI World EPS Estimates
Political risks remain a significant talking point if not a key driver to financial market returns this year. Some of the weakness in the US dollar can be attributed to the difficulties the US Administration faces in executing policy this year, but US equities have continued to move higher. We believe central banks remain key players in guiding our investment decisions. Both the Federal Reserve and the European Central Bank (ECB) committed to a policy normalisation that is ‘data dependent’. This indicates that the pace of adjustment is likely to be slow and considered, and hence supports further asset price gains. But with investor behaviour (good and bad) also likely to follow in line, we are reluctant to change overall risks levels in portfolios. This means we remain neutral on equites and underweight on fixed income. However, within equities, we are reducing some of our underweight on European markets, acknowledging some of the progress in economic activity but still being mindful of more structural policy constraints. In fixed income, we are seeking better risk diversifiers than in traditional debt, such as insurance-linked securities where portfolios allow.
Therefore, our thoughts by asset class are as follows:
Equity returns this year have been helped by strong earnings as much as by a reach for yield. We continue to favour Japan and emerging markets over Europe on a relative value basis and our style bias naturally tilts to value stocks. Despite the rise in markets, there is concern with the underperformance of value and size factors. But with many other risk factors in our analysis suggesting the environment is positive for equity returns, we have maintained our neutral exposure.
US markets remain expensive based on historic multiples and relative to other regions. While the US Federal Reserve interest rate has increased to between 1.00% and 1.25%, low unemployment and low mortgage rates should be supportive for the consumer, and hence economic activity. This supports our commitment to a neutral weighting.
Source: JP Morgan
Policy uncertainty in the UK is likely to be a recurring theme in the medium term, particularly after the recent election results. The domestic economy faces headwinds from prolonged Brexit negotiations and higher inflation, while the central bank seeks to balance growth and inflation objectives. But with FTSE 100 companies deriving a substantial amount of their revenues from abroad, a weaker currency can continue to support earnings and asset prices. Hence we retain a neutral weighting to the UK.
Emerging markets have performed strongly this year and we retain our positive view. Our analysis shows real GDP growth accelerating this year, particularly in Asia, and with muted US Dollar appreciation, corporate earnings have continued to improve. We expect little in the way of policy changes in China which further supports the positive momentum in the region.
Our aversion to interest rate risk remains – particularly after the decline in bond yields this year. What is most striking is that after successive Federal Reserve interest rate increases in the US and higher inflation, longer-dated bond yields are lower, not higher, than before the tightening cycle began. Pessimists would suggest that this signals likely recessionary conditions ahead but we would attribute this more to technical supply and demand factors. Shorter-dated securities offer better opportunities than longer-dated ones, so we continue to allocate to higher yielding risk diversifiers in our fixed income allocations. We have noted the record low yield levels in High Yield and prefer to reallocate to insurance- linked securities where appropriate which offer better diversification and lower correlations with stocks.
Gold and Foreign Exchange
We continue to favour gold as a risk diversifier. Political uncertainty and any reversion of recent disinflationary themes should be supportive for the commodity. The US dollar has underperformed this year but we are favourably disposed to the currency as interest rate differentials versus UK and Europe will remain supportive.
Following the Brexit referendum, a weaker exchange rate is not surprising and likely to assist the rebalancing of the economy. We have resisted covering our underweight to Sterling, despite its cheapness on a trade-weighted basis. This is mainly based on a weaker than expected output from the UK economy and the lack of higher interest rate support.
The global economy continues to benefit from the support of central banks and persistent profit growth, which bodes well for equity markets. Low realised volatility and even higher valuations, however, warrant caution and we have therefore sought to target returns across specific regions and styles, rather than extending our allocation to equities overall. Emerging markets and Japan are our favoured regions.
In fixed income, the likely return from extending interest rate risk is poor. We find better opportunities in emerging market debt, insurance-linked securities and investment grade bonds rather than high-yield and developed-market government debt.
Sterling may continue to underperform, so we prefer non-UK currency exposures. Gold offers diversification benefits, as does the US dollar as a safe haven currency.
Overall, our risk levels have remained the same as last quarter, due to continued positive macroeconomic fundamentals and extended valuations across most asset classes.