Our latest asset allocation meeting highlighted that global growth continues to surprise on the upside due to higher metals prices and a weaker US Dollar. Our liquidity preference model reaffirms the improved trajectory for most regions with the exception of the UK. In the US, factory orders, durable goods orders, recent ISM Manufacturing Index readings and retail sales all point to a healthy level of activity. Despite the likely impact of weather-related incidents, the US economy is growing solidly with contained inflation and, most significantly, a negative real effective federal funds rate, despite four rate hikes in the past two years. This should prove supportive for risk assets. The only negative signal we see is in credit conditions, where the decrease in commercial and industrial loans sits uncomfortably with record low yield levels in corporate bond markets, particularly for high-yield bonds.
Commercial & Industrial Loans at All Commercial Banks
In Europe, our growth indicators suggest a stronger GDP outturn this year. Purchasing Managers Indices, however, are starting to roll over and the surge in the euro against other currencies this year may weigh on corporate earnings. Emerging markets look more attractive with relatively strong growth, compared with developed markets. This should be supportive for corporate earnings and regional equity valuations are at a discount of approximately 30%.
Geopolitical events in North Korea present a near-term challenge, particularly for our Japan exposure. To-date, we have learnt to focus on policy rather than politics, and with other risk diversifiers available in the form of cash and gold, we maintain our positive view on Japanese stocks. Valuations are lower than in other developed markets, the currency is relatively cheap and we have exposure to small-cap rather than large-cap companies.
In the UK, the headwinds to growth remain negative real incomes, falling consumer confidence and, of course, protracted Brexit uncertainty. That said, UK equities have benefited from a weaker currency and it is noticeable that, relative to most other currencies, sterling has continued to depreciate and remains unloved. The point of maximum bearishness may, however, be at hand – few commentators expect a positive outcome in Brexit negotiations, central bank rate increases have been pushed out to 2019 and ten-year gilt yields have tested their lows for the year at 1%. Recognising this, we have revised our currency view on sterling from negative to neutral and are mindful of the possible effect on prospective returns from overseas assets if sterling starts to recover.
Foreign Exchange Valuation
Source: Deutsche Bank/Sandaire
Our detailed conclusions by asset class are as follows:
We maintain our neutral exposure to equities. Our preference remains for exposure to emerging markets and Japan rather than Europe. We are neutral on the UK and the US markets. The latter is supported by higher earnings estimates and a slow but steady expansion, but the outperformance of the US is such that valuations are stretched relative to the rest of the world. We are also aware of the lack of breadth in the recent rally but, with recession risks some way off, we find the risk and reward broadly balanced.
In Japan, despite geo-political uncertainties, the economy continues to improve and the Bank of Japan is still anchoring short- and long-term rates. We continue to favour exposure to small and mid-cap companies, which have outperformed this year.
Conversely, in the UK, a weakening domestic economy favours more large-cap exposure, especially given the large outperformance by smaller companies of the broader indices to-date. Within the MSCI World, we note the relative cheapness of UK stocks, but with Brexit noise and currency fluctuations dominating, we prefer to be neutral-weighted to the US market.
Fixed Income markets have outperformed of late as inflation expectations have moderated and central banks, particularly in the US and Europe, continue to tread carefully in their policy adjustments.
In the US, we have downgraded our view on US High Yield to negative from neutral. Bond yields for non-investment grade borrowers are at record lows at the same time as leverage (net debt to earnings) is close to post-crisis highs. Interest cover has also declined. With a high degree of correlation between High Yield and US equities, we consider the risk and reward of reaching for yield in this market to be increasingly unappealing.
Source: JP Morgan Asset Management
Gold & Foreign Exchange
Gold has performed well this year returning 14.72% in USD terms to the end of August. We continue to like gold as a risk diversifier. Political uncertainty and any reversion of disinflationary themes should continue to be supportive, although we are conscious of the strong outperformance year-to-date.
In currencies, we have reverted back to neutral on our exposure to GBP and USD. The sharp depreciation in sterling since the referendum makes the currency cheap on most long-term measures of value. We think the members of the Monetary Policy Committee (MPC) will have greater concern over high import prices and the impact on consumers than the benefit of cheaper imports to companies. This may result in a more hawkish policy view which the market has yet to discount. Any good news on Brexit may also reverse some of the negative sentiment weighing on the currency.
Growth appears to be well-supported across most of the global economy. With inflation moderating this continues to support risk assets. Central banks continue to move cautiously in removing policy accommodation and hence the relative attraction of equities over lower-yielding fixed income remains.
Developing markets can continue to do well as long as accelerated rate hikes and any major government policy initiatives in the US do not act as a material drag on earnings or growth.
Europe has surprised this year with the economy forecast to grow above 2%, but the effects of a stronger currency, particularly with low inflation, will not help peripheral country economies with high debt levels.
Our portfolios are neutral on equities but underweight fixed income. We persist with allocations to cash and gold as alternative risk diversifiers. This should balance some of the beta we have to emerging markets and private investments where permitted.