Improvement in Financial Conditions Can Continue, Driven by Excess Liquidity, Dovish Central Banks, Low Inflation and an Improving Global Backdrop

By Michael Stanes, Investment Director at Heartwood Investment Management

The global economy is presenting a positive picture with both developed and emerging markets contributing to growth. The improvement in global conditions has coincided with rising financial market confidence. We appear to be in a steady state of equity markets grinding higher, gently rising bond yields and low volatility. Recognising that we are in an unusually extended market cycle, with markets now eight years on from their Global Financial Crisis lows, we believe that the improvement in financial conditions can continue in the near term, driven by excess liquidity, still dovish central banks and an improving global backdrop, with inflation not expected to run into the danger zone. That said, we acknowledge that valuations across developed market equity indices are looking more expensive and credit spreads are at historic lows (the yield difference versus the equivalent maturity sovereign bond). We are therefore comfortable with the current moderate risk overweight, but have little inclination to add further to risk levels.

Equities: Notwithstanding the positive and improving growth outlook, our view remains that a modest overweight in equity is appropriate. The ‘reflation trade’ continues to dominate the market narrative, despite the bond market showing some scepticism that the growth momentum can be maintained. Valuations and performance prevent a more positive stance toward equity overall, particularly with event risk in Europe and some uncertainty around the pace of US policy moves. We retain our positive view on US equities beyond the immediate future, maintaining our slant to cyclical stocks. We have also added to positions in healthcare, where we see long-term opportunities to benefit from ageing demographics and new therapeutic discoveries. Our overweight in European equities remains a contrarian trade, but we believe this region will benefit from a corporate earnings recovery as fundamentals improve. Similarly, we expect these trends to also support Japanese equities. We remain underweight in UK equity and believe it is too early to repatriate assets. In emerging markets, we maintain our overweight position but would not add to it at this point, given its recent resilience and possible risk of a trade policy shock out of the US.

Bonds: Interest rate policy divergence is emerging as a stronger theme in developed sovereign bond markets. Over the last month, US treasury yields have drifted higher on the re-pricing of interest rate expectations, while UK gilts, in particular, have outperformed despite a backdrop of increasing inflation. We believe that being short duration remains appropriate in the current environment of improving global growth and reflation. Credit markets should continue to be supported by improving economic fundamentals, although supply has weighed on some parts of the market more recently. In a Fed tightening environment, leveraged loans have seen notable outperformance. We continue to have select exposure to shorter-dated investment grade corporate bonds, specialist lenders and emerging market sovereign debt. 

Property: UK property developers and listed vehicles have performed well of late, supported by better than expected fourth quarter results and the rally in UK gilt yields. Nonetheless, there are few catalysts that we can see in favour of this market over the medium term, given uncertainty around Brexit, and we believe it would be too soon to add. Our underweight in UK commercial property remains intact based on the supply outlook, especially in the South East. Across sectors, we continue to seek income opportunities in the industrials and offices. On a regional basis, we are invested in cities outside of London, which are less exposed to the ‘Brexit’ fallout. Outside of the UK, we are also looking at opportunities in the US REIT (real estate investment trust) market, although we remain wary of the impact of the Fed’s more hawkish stance. 

Commodities: Until mid-March, the low volatility and tight trading range of the oil price have been noteworthy this year and we did not expect this situation to last. Concerns around inventory levels and the discipline of OPEC producers keeping to agreed limits are now testing the market’s resolve, leading to the oil price sliding to a three-month low. Despite the sell-off, we continue to expect that an improving global economic environment, reflation and a tighter supply/demand balance will ultimately be supportive to commodities this year. Direct access to this market is through owning futures contracts rather than the physical assets and while the risk/return profiles are looking more attractive across some parts of the complex, they are not yet at levels where we are ready to invest. We have, though, a position gold in some strategies for diversification. 

Hedge funds: While we have held a limited allocation to hedge funds in recent years on concerns around performance, we believe that increasing interest rate divergence should create more opportunities going forward. Our preference remains for macro/CTA strategies, but we are also taking a more positive view on equity hedge strategies, given the greater likelihood of increased stock dispersion (i.e. between winners and losers), as well as credit long/short strategies. 

Cash: We have reasonable levels of liquidity across our portfolios both in cash and short-dated bonds, which we are ready to invest as and when we see specific opportunities. Market volatility remains low, a situation unlikely to persist throughout 2017.

By Michael Stanes, Investment Director at Heartwood Investment Management

The global economy is presenting a positive picture with both developed and emerging markets contributing to growth. The improvement in global conditions has coincided with rising financial market confidence. We appear to be in a steady state of equity markets grinding higher, gently rising bond yields and low volatility. Recognising that we are in an unusually extended market cycle, with markets now eight years on from their Global Financial Crisis lows, we believe that the improvement in financial conditions can continue in the near term, driven by excess liquidity, still dovish central banks and an improving global backdrop, with inflation not expected to run into the danger zone. That said, we acknowledge that valuations across developed market equity indices are looking more expensive and credit spreads are at historic lows (the yield difference versus the equivalent maturity sovereign bond). We are therefore comfortable with the current moderate risk overweight, but have little inclination to add further to risk levels.

Equities: Notwithstanding the positive and improving growth outlook, our view remains that a modest overweight in equity is appropriate. The ‘reflation trade’ continues to dominate the market narrative, despite the bond market showing some scepticism that the growth momentum can be maintained. Valuations and performance prevent a more positive stance toward equity overall, particularly with event risk in Europe and some uncertainty around the pace of US policy moves. We retain our positive view on US equities beyond the immediate future, maintaining our slant to cyclical stocks. We have also added to positions in healthcare, where we see long-term opportunities to benefit from ageing demographics and new therapeutic discoveries. Our overweight in European equities remains a contrarian trade, but we believe this region will benefit from a corporate earnings recovery as fundamentals improve. Similarly, we expect these trends to also support Japanese equities. We remain underweight in UK equity and believe it is too early to repatriate assets. In emerging markets, we maintain our overweight position but would not add to it at this point, given its recent resilience and possible risk of a trade policy shock out of the US.

Bonds: Interest rate policy divergence is emerging as a stronger theme in developed sovereign bond markets. Over the last month, US treasury yields have drifted higher on the re-pricing of interest rate expectations, while UK gilts, in particular, have outperformed despite a backdrop of increasing inflation. We believe that being short duration remains appropriate in the current environment of improving global growth and reflation. Credit markets should continue to be supported by improving economic fundamentals, although supply has weighed on some parts of the market more recently. In a Fed tightening environment, leveraged loans have seen notable outperformance. We continue to have select exposure to shorter-dated investment grade corporate bonds, specialist lenders and emerging market sovereign debt. 

Property: UK property developers and listed vehicles have performed well of late, supported by better than expected fourth quarter results and the rally in UK gilt yields. Nonetheless, there are few catalysts that we can see in favour of this market over the medium term, given uncertainty around Brexit, and we believe it would be too soon to add. Our underweight in UK commercial property remains intact based on the supply outlook, especially in the South East. Across sectors, we continue to seek income opportunities in the industrials and offices. On a regional basis, we are invested in cities outside of London, which are less exposed to the ‘Brexit’ fallout. Outside of the UK, we are also looking at opportunities in the US REIT (real estate investment trust) market, although we remain wary of the impact of the Fed’s more hawkish stance. 

Commodities: Until mid-March, the low volatility and tight trading range of the oil price have been noteworthy this year and we did not expect this situation to last. Concerns around inventory levels and the discipline of OPEC producers keeping to agreed limits are now testing the market’s resolve, leading to the oil price sliding to a three-month low. Despite the sell-off, we continue to expect that an improving global economic environment, reflation and a tighter supply/demand balance will ultimately be supportive to commodities this year. Direct access to this market is through owning futures contracts rather than the physical assets and while the risk/return profiles are looking more attractive across some parts of the complex, they are not yet at levels where we are ready to invest. We have, though, a position gold in some strategies for diversification. 

Hedge funds: While we have held a limited allocation to hedge funds in recent years on concerns around performance, we believe that increasing interest rate divergence should create more opportunities going forward. Our preference remains for macro/CTA strategies, but we are also taking a more positive view on equity hedge strategies, given the greater likelihood of increased stock dispersion (i.e. between winners and losers), as well as credit long/short strategies. 

Cash: We have reasonable levels of liquidity across our portfolios both in cash and short-dated bonds, which we are ready to invest as and when we see specific opportunities. Market volatility remains low, a situation unlikely to persist throughout 2017.