Fixed Income: David Absolon
Reflation and the passing of the baton from central banks to governments are two themes that are likely to be the key performance drivers of global fixed income markets. Moreover, both of these trends are expected to contribute to stronger global growth in the first half of 2017, with the US economy taking the lead based on expectations of significant fiscal expansion. Stable growth in China and grinding recoveries in the eurozone and Japan should also help to support an improving global backdrop. The exception to this trend is the UK, which is mired in Brexit and where downside risks to growth have increased.
Global deflation concerns have lost momentum, thanks to the recovery in commodity prices, and the trend of gradual, but not accelerating, reflation should continue in 2017. Core inflation is likely to drift higher in the US, although remaining well anchored as the strength of the US dollar is maintained. Headline inflation measures will be sensitive to the base effect of energy prices, most likely felt in the first quarter, and this may lead to some volatility at the headline level. Wage pressures are expected to rise moderately across developed economies as labour market conditions have tightened progressively over the past couple of years, especially in the US.
The US economy provides the strongest prospects for meaningful fiscal expansion, given plans for a $1 trillion plus infrastructure boost. However, hopes of a coordinated global fiscal pact remain a pipe dream. A ballooning budget deficit keeps the UK government timid about freeing the fiscal purse strings, as eurozone governments also show a lack of ambition.
Global central bank policy will remain accommodative, but unlike the past couple of years, and following questions around the role of central banks and the effectiveness of their policies, we are unlikely to see the injection of massive liquidity into financial markets. Those days appear to be over and we expect central banks to take a more balanced tone.
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Developed sovereign bond yields are expected to rise, led by the US, but the trend will be capped by ongoing structural demand and the safe haven status in an environment of higher political risk premia. We are cautious about rising leverage in US corporate markets and continue to search for value where we opportunities for fundamental improvements. Notwithstanding headwinds around US policy uncertainty, emerging market sovereign debt is a long-term opportunity based on structural economic improvements.
Equities: Michael Stanes
Populist politics has been the theme of 2016 and will likely remain in place over the next few years. Donald Trump’s election has shifted the narrative of markets, where perceptions are now focused on a pro-growth policy agenda and reflation.
As investors consider the implications of a shifting political climate, there is a risk that expectations for a significant growth boost are overstretched. In reality, we have yet to see any actual stimulus being implemented, although the political hurdles of delivering fiscal expansion have been reduced in the US.
We will retain our preference for value, overweighting the cyclical markets of Europe and Japan. Europe and Japan represent good value relative to other developed markets and should benefit from an improving corporate earnings backdrop. For various reasons, Europe has been a market that has not been favoured by global investors on worries about political risks, slow growth and a fragile Italian banking sector. Acknowledging that any one of these risks could erupt at any point to undermine sentiment, we are reassured by the fact that financial markets are better supported by policy measures already in place, with the European Central Bank acting as a backstop. The credit cycle remains pivotal to the eurozone’s recovery, where progress is being made, albeit slowly. Financial conditions remain very loose as the ECB continues to purchase assets in early 2017.
Japan is another unloved equity market based on a lacklustre macro environment and disappointing policy outcomes, whether through ‘Abenomics’ or the diminishing impact of Bank of Japan stimulus. Our reasons for investing, though, are less beholden to policy expectations, but focused on the micro story, where corporate governance developments are driving efforts to improve shareholder value. We also believe there are interesting opportunities to be found in the ‘New Japan’, which includes domestically-focused sectors positioned to benefit from ageing demographics (healthcare and consumer discretionary) and digital advancements.
We expect to be maintaining our modest overweight to US equities, although exposure will remain targeted to specific areas: domestically-exposed small caps and sector opportunities in industrials. A significant amount of global money has been invested into US equities, driven by expectations of higher US growth, gradual reflation and a positive sloping yield curve. We expect this positive momentum to be maintained in early 2017, reinforced by expectations of improved corporate earnings growth, given the fading effects of the commodity price adjustment and a stronger US dollar.
Inevitably, US politics throws up uncertainties under a Trump presidency and the risk of disappointment or of a policy blunder remain significant. On balance, though, we take a more optimistic view. If Trump’s policy priorities are focused on recharging US growth and bringing forward spending, then this is likely to boost US equities at the expense of the US treasury market. Furthermore, the Republican Party’s control of both the presidency and Congress increases the likelihood that economic measures will get implemented, plus Congressional Democrats are likely to support infrastructure spending. Any vacillation in advancing the pro-growth agenda will be more related to tax cuts, where there is less of a consensus between the two parties. However, tax incentives to repatriate US companies’ global earnings could add further support to US equities, as well as drive merger and acquisition activity and share buybacks.
Downside risks to growth in 2017 and Brexit vulnerabilities keep us underweight in UK equities in the near term. We will remain focused on large-cap exporters in the near term, although domestically-focused smaller companies could provide opportunities over the medium term as we see more visibility around Brexit and a stable currency. Over time, we are likely to look to repatriate assets back into UK equities, although the post-Brexit bounce has delayed that prospect as overseas investors were attracted into the market by a weaker sterling.
A key question for global equity investors in 2017 is what will be the impact of a shifting political and economic environment on emerging market equities? US policy uncertainty will keep EM sentiment vulnerable in the near term on further talk of imposing trade barriers, although a measured Federal Reserve tightening cycle is unlikely to act as a significant constraint on EM economies. The era of advancing free trade agreements appears to be over, at least for now. We already know that the US will issue a notice of intent to pull out of the Trans Pacific Partnership Agreement, but this move might not be all bad for China, acting as the regional pivot and reinforcing supply chains within Asia. If the US were to abandon the North American Free Trade Agreement, this would have a more meaningful impact on broader EM sentiment, not just Mexico. Away from US-exposed EM economies, there are diversification opportunities in Eastern Europe, which are positioned to benefit from recovering eurozone demand.
We are retaining our modest overweight allocation to EM equities with a view to increasing exposure as we see more clarity around the policy environment. We believe that an allocation to EM assets represents a long-term opportunity due to structural economic improvements – low budget deficits relative to GDP, current account surpluses and the buffer of ample foreign exchange reserves – and opportunities through the development of banking systems, telecommunications and consumer services. Valuations are not expensive relative to developed markets and there is more scope for corporate earnings improvements, given cyclical improvements in late 2016.
Commodities: Jade Fu
Compared with the start of 2016, our view on the commodity complex has become more constructive, owing to fundamental improvements that are being driven by a tighter supply/demand balance. Moreover, the significant price shock since mid-2014, coinciding with the end of the commodity super-cycle era, appears now to be accepted by investors and expectations have been reset. Perceptions of increased fiscal spending the US and policymakers’ commitment to revive growth have further boosted sentiment towards commodities.
Notwithstanding this more positive outlook, we believe it prudent to remain underweight in commodities from a portfolio construction perspective. Direct access to this market is through owning futures contracts rather than owning the physical asset. However, the risk/return profile is unappealing, in our view, due to the way these contracts are currently priced. The spot price trades below the futures price and as these contracts expire and are rolled forward this presents a negative yield. We prefer to take indirect exposure to commodities through other asset classes (equity and debt). That said, we will continue to hold a modest position in gold in certain strategies for diversification reasons
In energy, the evidence suggests an improving supply and demand outlook in the first half of 2017, driven by falling rig counts in the US and more stable growth in China. OPEC’s decision to cut supply to 32.5 million barrels per day does not shift the outlook materially, although it marks an important step in maintaining OPEC’s credibility with the markets and should support sentiment in the near term. It is worth remembering that even with the OPEC reduction, the supply of oil is still higher than a year ago, and continues to remain at a multi-year high. Oversupply remains a persistent theme in longer term and will keep a lid on prices. Furthermore, as oil prices recover, US shale supply is likely to increase given how quickly and efficiently production can be resumed.
Industrial metals prices have rallied strongly since the US election and may now be over-extended, given much of it has been driven by momentum and sentiment. Nonetheless, the fundamental outlook for industrial metals has improved on supply constraints, with the closure of mines and the reduction of inventories. While demand remains sluggish, further economic improvements in China and expectations of US fiscal expansion could add support to the market. However, there is a risk that policymakers in China could impose tighter controls on the property market – an important bellwether of demand for copper and steel – which would be negative for base metal prices.
Our view remains constructive on precious metals, although performance closely follows the perceived course of global monetary policy. A lower for longer environment will be supportive for precious metals overall. However, if inflation expectations were to accelerate as well as the pace of Federal Reserve rate hikes, the environment could be more challenging. Our central view, though, continues to expect both gradual tightening and reflation.
Alternatives: Charu Lahiri
Brexit adds a layer of uncertainty for UK commercial property and will accelerate structural headwinds that had already emerged before the referendum. Even prior to the UK referendum result, there were signs that some areas had become overheated, such as London offices and commercial and retail property in the South East, where – in certain areas – yields had fallen to pre-2008 crisis levels against a backdrop of supply constraints and low vacancy rates. Significant levels of capital flows since 2012 had also risen to record highs.
The full impact of Brexit continues to be assessed across property markets with varying signals. Clear signs have emerged from buyers that assets secured by long term, inflation-linked income streams are maintaining their value, as are ‘specialist’ investment vehicles. Elsewhere, developers have suffered materially and some prices are looking distressed, offering potential tactical opportunities on a medium-term view.
We expect to maintain our underweight allocation to this asset class, keeping a focus on diversification and selectivity. We hold exposure to regional offices and industrials, which should benefit from rising rental income growth due to supply constraints and falling vacancy rates. These markets are expected to be more insulated from a ‘hard’ Brexit scenario plus benefit from lower business rates – whereas London retailers contend with higher rates. From a macro perspective, we expect the Bank of England to maintain interest rates at historically low levels, given downside risks to growth – though not at recessionary levels – which should underpin demand for higher yielding assets. Sterling’s depreciation is likely to boost the attractiveness of the UK market to international investors. Notwithstanding Brexit noise, UK property continues to attract international buyers due to its “safe haven” qualities and the UK’s robust jurisdictional and legal framework.
Outside of the UK, other markets are less attractive from valuations perspective. However, in the US, the real estate investment trust market has been susceptible to negative sentiment due to reflation and higher growth expectations. Valuations remain at the higher end of the range on a historic basis, but should this selling pressure continue to build, we may find a potential entry point.
In hedge funds, we have held a natural bias towards macro/CTA strategies, which we expect to benefit from greater global monetary policy divergence. Steeper yield curves also provide a better opportunity set for arbitrage-orientated macro strategies. Furthermore, we expect to see increased dispersion in equity market performance, which is also beneficial to most arbitrage strategies. We favour managers looking to trade around volatility rather than making long directional bets.
We are finding opportunities to participate in directly funding infrastructure projects and supplying loans to small- and medium-sized enterprises. There has been a secular change in the corporate lending space since the 2008 financial crisis as banks have retrenched from the market, resulting from regulatory and capital requirement pressures. This gap is now being filled by specialist alternative lenders. These strategies offer a yield premium over higher yielding corporate bonds, often have lower default and higher recovery rates, and typically have a low correlation to broader equity and bond markets.