Notwithstanding various data disappointments over the past month, mainly reflecting business surveys moderately descending from elevated levels, actual activity remains firm and the global backdrop supportive for financial markets. This environment can be characterised by modest nominal growth, ongoing central bank support and improving corporate earnings.
Since March the market narrative has suggested less enthusiasm for the reflation trade across most asset classes, resulting in investors favouring growth over value. We believe some of this pessimism has been overdone and expect that the hurdles have now been lowered for markets to be positively surprised by data or policy announcements. While there is disappointment around the Trump administration’s ability to execute on pro-growth policies, we believe that any expression of intent to implement legislation, especially cutting corporate taxes, may be enough to reassure investors. That being said, we have no desire to add to risk levels from here and we retain our modest overweight exposure in risk assets. Our risk exposures are tilted towards more specific and targeted areas of the market, whether by sector or market-cap, to reflect our degree of confidence in the near-term fundamental outlook.
Although our view remains constructive in the shorter term, we can envisage being more cautious further out. We recognise that we are in the later stage of the market cycle and investor sentiment could be more vulnerable to potential pressure points as we move through the year. In particular, we would highlight the potential headwinds of higher US interest rates and tighter financial conditions in China. Indeed, one of the key elements to a stable financial environment over the last few years has been central bank support, which has been reflected in rising valuations across asset classes. Political risks also remain elevated, particularly in the UK, where we remain underweight domestic assets.
Equities: The backdrop remains generally supportive and our view remains that a modest overweight in equity is appropriate. Valuations and performance prevent a more positive stance towards equity overall, as we are mindful of potential event risk and being in the later stage of the market cycle. We wish to remain fully invested in the US (and no more given valuations), with more targeted exposure in healthcare, industrials and smaller companies. We are maintaining overweight positions in European and Japanese equities, which favour our pro-cyclical stance. In Japan, we have taken some exposure to smaller companies in our higher risk strategies. UK equity remains an underweight position and we believe it is still too soon to repatriate overseas assets, given domestic political uncertainties. We are maintaining a bias to UK larger companies, which have performed well as sterling has weakened over the last year. We increased our EM exposure versus DM in 2016 and are comfortable with the current modest overweight positioning. Over the shorter term, we may see some consolidation as EM equity has had a good run of late, although we are reassured by the trend in corporate earnings upgrades. The longer-term structural case remains intact. We believe EM assets will be supported by improving growth prospects, policy easing in several economies as inflation trends ease and ongoing liquidity flows.
Bonds: The loss of momentum in the reflation trade has benefited bond markets through lower inflation expectations and falling bond yields. With a slightly more hawkish Fed and with the ECB likely to consider its QE exit strategy, we believe that a short duration stance remains appropriate. Credit spreads – both US corporate credit and emerging market sovereign debt (hard and local currency) – continue to tighten given the solid growth backdrop.
Property: UK commercial property has seen improving activity since the end of last year as the economic backdrop has remained resilient. Nonetheless, there are certain potential headwinds that should not be ignored including slower UK growth, increased supply and a slowdown in rental growth as occupational demand declines. We retain our underweight position, believing this to be a prudent stance in light of UK political uncertainties, as well as acknowledging the maturity of the current cycle. On a regional basis, we are primarily invested in cities outside of London, which are less sensitive to Brexit and benefitting from more attractive supply/demand dynamics. Outside of the UK, we are also looking at opportunities in US REITs (real estate investment trusts), although for now we remain wary of the impact of the Fed’s more hawkish interest rate stance.
Commodities: Concerns around the effectiveness of OPEC production cuts to counter rising US production are likely to continue to weigh on the oil price, although these forces may be somewhat offset by an improving global economic environment. We are maintaining our position in gold as we continue to see it as an important diversifier for portfolios. Industrial/base metals prices have been pressured on concerns of slowing Chinese growth and any further tightening measures could weigh on this part of the complex.
Hedge funds: While we have held a limited allocation to hedge funds in recent years on concerns around performance, we believe that increasing monetary policy divergence should create more opportunities in this sector 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).
Cash: We have reasonable levels of liquidity across our portfolios both in cash and short-dated bonds, which we will invest as and when we see specific opportunities. Market volatility remains low – a situation that we believe is unlikely to persist as we move into the second half of the year.