By Graham Bishop, Investment Director at Heartwood Investment Management
The global economy benefited from a synchronised expansion in 2017 and momentum has accelerated over the last few months. While the legislative approval of US tax reform appears to be re-energising animal spirits, other forces are also playing their part: strengthening domestic growth in Europe, rising global capital expenditure levels, and the positive impact of stronger global demand for Chinese exports. Inevitably, questions are being asked about the sustainability of the current stronger global growth profile. We expect that a virtuous cycle of rising economic momentum, positive investor sentiment and supportive financial conditions will sustain the current cycle in the near term. In particular, US domestic growth prospects have been lifted by the temporary boost from fiscal stimulus, which arguably goes further than many had expected. While it is still early days, the impact of tax cuts is likely to be felt through higher wages and/or stronger corporate earnings.
However, we are also mindful that ten years on from the Financial Crisis this extended business cycle is reaching a mature phase. Several headwinds have held inflation down in the last few years, notably the euro sovereign crisis, which crippled demand in Europe, and tighter financial conditions in emerging market economies during the period when commodity prices collapse between 2014 and 2016. As these disinflationary headwinds diminish, we believe that the nature of the current extended cycle of low interest rates and low inflation is changing. Cyclical inflation pressures are rising moderately. While the boost from higher oil prices is likely to impact headline measures, the more important feed-through will come from the culmination of several months of strengthening global momentum. After all, in our view, inflation is a lagged a response to growth. Admittedly wage growth has been disappointing so far, but we expect that tighter labour market conditions will eventually produce higher wage pressures.
So it appears that we are entering a different stage of the cycle, likely to be characterised by more ‘normal’ conditions. Central banks are expected to stay on their journey of withdrawing emergency levels of monetary stimulus, as the regime shifts from quantitative easing to quantitative tightening. This expected reduction in excess liquidity growth is likely to present more challenges to markets further out, given its potential impact on earnings and sentiment. Moreover, despite the bond market’s recent revision towards a higher interest rate environment, we still believe that there remains a certain amount of complacency within financial markets. For example, financial conditions in the US have eased over the past year and there is still some way to go to normalise policy, especially if inflation rises as we anticipate.
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We are therefore comfortable with maintaining our neutral exposure to risk assets. However, we also consider it to be appropriate to slightly reduce the cash position based on our short-term positive view. Rather than adding to equity risk, given the high valuations of some parts of the market, we are modestly increasing our commodity exposure to reflect our view of a reflationary environment. In our lower risk strategies, we are also modestly adding to short-term emerging market sovereign debt, which continues to benefit from benign economic conditions. Portfolios continue to hold a tilt towards the more value-orientated parts of the market, which we believe are positioned to withstand a higher interest rate environment. We are also sourcing diversified return streams from alternative assets, which should benefit from an environment of higher levels of market volatility.
Bonds: Inflation expectations are picking up and shorter- and intermediate-dated sovereign bond yields in developed markets are re-pricing to reflect a slightly faster US Federal Reserve interest rate tightening cycle. More focus is also being placed on the likely policy path of the European Central Bank, as its quantitative easing programme could end this September. The strong fundamental backdrop continues to support credit markets and, for this reason, we modestly added to emerging market sovereign debt. Overall, we continue to believe that developed sovereign bond valuations remain unattractive and maintain our short duration position. We are targeting ‘niche’ return drivers, such as asset-backed securities and infrastructure loans, until value returns to conventional credit.
Equities: 2017 ended on a strong note, with good news on the US tax bill adding support to developed markets. We continue to believe a modest overweight allocation to equities remains appropriate, mindful that the strong fundamental and liquidity backdrop are juxtaposed against the risks of high valuations and a lack of volatility. We are still not pushing for a shift back to UK equities at the expense of overseas, remaining underweight relative to other regions. We retain overweight positions in European and Japanese equities. We are neutral in US equities and remain comfortable taking a targeted approach to specific themes – healthcare, insurance and small cap. We continue to view our US exposure as a future source of funds on valuation grounds. Our emerging market equity exposure remains tilted towards Asia and we would view any pullback as an opportunity to add.
Property: The UK commercial real estate market ended 2017 strongly, having defied the Brexit gloom and continuing to attract the interest of overseas investors. We are comfortable maintaining our underweight position in UK commercial property, favouring a targeted approach towards long-term income strategies. Our preference remains for those sectors where there are supply/demand imbalances and are less exposed to broader macroeconomic events. While capital appreciation opportunities are diminishing given the maturity of the cycle, we continue to believe that UK commercial property offers attractive yields over UK gilts, which continue to be above historic averages in most sectors.
Commodities: We are increasing our exposure to commodities to reflect our more positive short-term view of a reflationary environment. While the oil price has seen a significant rally on a tightening supply/demand outlook, we believe that the fundamental backdrop remains supportive in the near term. OPEC discipline has been noteworthy and a higher oil price from current levels would be welcomed by Saudi Arabia given its growing fiscal deficit. Further out, we are mindful of the risks of US shale production resuming. Industrial metals are sensitive to rebalancing and deleveraging in China, but environmental controls introduce supply-side constraints which could be supportive to prices. Gold continues to play a protective role in portfolios in the event of any financial or geopolitical crisis.
Hedge funds: We made no change to our current allocation, although we expect more opportunities to arise owing to increasing monetary policy divergence and sector and stock dispersion. Our preference remains for macro/CTA strategies, as well as equity hedge strategies that have the potential to benefit from increased stock dispersion (i.e. between winners and losers).
Cash: We have slightly reduced our cash weighting, but continue to maintain reasonable levels of liquidity across our portfolios both in cash and short-dated bonds. Market volatility remains low – a situation that we believe is unlikely to persist as we move into the second half of the year