Ten years after the collapse of Lehman Brothers, commentators have much to reflect on. Global demand has recovered, albeit slowly; central banks are desperate to normalise monetary policy and asset prices from bonds to equities are at record highs. What has not changed though is the level of debt accumulation. At the end of 2017, government and non-financial corporate indebtedness reached $134 trillion compared to $78 trillion in 2007*. It is no wonder then that market sensitivities to the level of interest rates and the strength of the US dollar are so high.

As we reflect on third quarter returns, there has been a persistent and notable under-performance in Emerging Market assets – from bonds to equities, Asia to South America. Higher US interest rates, a stronger US dollar and trade tariffs have all been cited as reasons for the divergent performance. Our proprietary model for gauging risk appetite (Sandaire’s Liquidity Preference Model), however, suggests that there has been only a modest weakening in global growth this quarter. Inflation expectations appear to have moderated. Volatility has come down from Q1 2018 levels and some economic leading indicators have declined over the summer but from a historically high level. With regard to trade, as complex and challenging as it is to map out the longer-term consequences on growth, we see a risk that the imposition of tariffs by the US and China may spread from their largely bilateral nature. The direct impact of the tariffs announced to date is not material to economic growth. All of which suggests a reasonably good environment for risk-taking, notwithstanding some difficult headlines and divergent returns.

In line with the twin effects of positive growth but tighter liquidity conditions, we are maintaining our neutral weighting to equities. By region, there is much to consider.

In the US, economic growth remains strong, fuelling corporate earnings, which have also been bolstered by tax cuts. These have validated the strong performance of US equities to date. The pick-up in wage growth bodes well for household spending and Fed Chairman Powell remains optimistic about the risks to inflation. In short, there is nothing fundamentally to dislike about the US market. Weighed against this are: historically high valuations; equity risk premia have turned negative; expectations for earnings are at record highs (see chart); and the US is more fiscally profligate than at any time since the war. Capitulating and going overweight at these higher levels after such a strong period of outperformance seems like the wrong thing to do. Hence we remain neutral on US equities.

US earnings (EPS) expectations are extremely high for this stage in the cycle

 

Our positive view on Emerging Markets has not worked well this year. We reduced our holdings to EM debt in June as idiosyncratic risks in Turkey and Russia escalated. But the underperformance in EM equities has surprised and appears more systematic than idiosyncratic. We believe this is overdone. EM growth has slowed but remains respectable. Prices are stable, although recent currency declines may challenge such expectations. And China has tools to manage any downturn in the credit cycle. Given the sharp underperformance in EM equities, we maintain our overweight view.

Managing the risks around an escalation in trade wars, however, prompts us to revisit our weighting to Europe. We have concluded that moving to an underweight position is warranted. This is underpinned by a number of factors. The pace of inflation has failed to pick up in Europe as foreign demand has fallen. Europe has an outsized exposure to global trade which makes it vulnerable to a further leg down if trade wars escalate. Moreover, the slow pace of reform in Europe makes a material policy response to offset these effects very unlikely. Add to that, the greater potential monetary policy response in China compared to Europe, Brexit-related effects and possible negative outcome to budget negotiations in Italy, the relative attractions for investors in European equities appears slim.

After the dip in Q1 2018, the UK economy has recovered, but growth remains weak compared to Europe (see chart). Core inflation remains high and close to 2%, helped by the persistent weakness in Sterling. Despite tighter labour markets, however, real wage growth is slow and weighing on consumption. All of this should not be a surprise and explains some of the underperformance in UK stocks. Add to this the agonising Brexit negotiations and a lack of clarity on any outcomes and it is hard to be constructive on valuations. As a consequence, we remain negative on UK assets.

UK Growth has steadied but remains low by historic measures

While we find many reasons to be cautious on Western markets, we like Japanese equities and reaffirm our overweight position. Supportive central bank policies, shareholder-friendly reforms, a more stable government and a cheap currency underpin our view. The prospect of a consumption tax increase, earmarked for October 2019, poses a risk given prior policy mistakes (e.g. 2014), but we believe the government would be sensitive to this. We are more encouraged to believe that with private demand picking up, particularly in investment, there would be a natural offset to this.

In Fixed Income, returns have been poor with the exception of US High Yield. We would expect this to continue and remain negative both on interest rate risk and credit risk. The Federal Reserve will maintain its bias to raise interest rates through much of next year. Longer term bond yields have failed to move materially higher but the risks are rising and the cushion for any acceleration in the pace of tightening is limited. We believe flatter yield curves are not to be misinterpreted as signalling recession but more reflective of structural trends in the ownership of longer dated bonds. Hence US Treasuries are not yet cheap. We prefer to allocate instead to US TIPS (Treasury Inflation Protected Securities) where valuations are below the Federal Reserve’s forecast of inflation.

US TIPS compared to Federal Reserve Inflation Target

In credit markets, spreads remain narrow as higher earnings offset the tighter liquidity conditions. We are concerned by the increase in leverage in both High Yield and Investment Grade corporate debt (see chart) and have limited exposure to either asset class. Our preference is for fixed income strategies that are either uncorrelated with traditional market beta or benchmark returns, and those that are more exposed to consumer credit rather than corporate credit. Our fund selection reflects this. In Emerging Markets, we have seen both hard and local currency debt markets underperform, but we are loathe to reinitiate a position until idiosyncratic risks in Argentina, Turkey and Russia start to moderate.

 

Outside of our traditional exposure to equities and fixed income, we retain an allocation to gold. Although the gold price has weakened this year, we consider its defensive qualities to be important when markets are at extremes, with either accelerating or decelerating inflation. As labour markets tighten to levels not seen for years and we approach the end of the current business cycle, we see our gold exposure as a complement to our TIPs exposure.

Our allocation to hedge funds is confined to macro and volatility managers. The environment has been challenging for this sector, as few central banks have followed the lead of the Federal Reserve and volatility has failed to remain high this year. While this has not been helpful for our managers, it has been beneficial for our equity exposure overall, emphasising the diversification benefits of multi-asset exposure.

To conclude, our adjustments this quarter have been confined to equities where we have reallocated some of our European exposure to other regions. This should help balance the risks of further deterioration in trade negotiations while retaining any upside from continued strong earnings. We nonetheless remain alert to the risks in Emerging Markets and China. In Fixed Income, less is more as we seek to avoid duration and credit risk in favour of more uncorrelated exposures.

Kevin Corrigan, Chief Investment Officer

*source IIF Global Debt Monitor – May 2018