By Michael Stanes, Investment Director at Heartwood Investment Management
Benign economic conditions, strong corporate earnings results in aggregate across regions and reduced political risks remain supportive of our pro-cyclical stance in the near term. While the so-called ‘reflation trade’ has suffered a modest setback over recent weeks, mainly arising from frustration around President Trump’s ability to deliver tax cuts, we expect markets to take a somewhat more positive view of growth-friendly US policy changes, further supported by growth that is durable, liquidity stimulated by ongoing central bank accommodation, and corporate earnings improvements. US policy outcomes are uncertain, but it is our view that if the Trump administration can at least make some headway on its proposals, such as tax relief on overseas cash repatriation, then this cannot be ignored for its potentially positive impact on US capital expenditure and broader economic activity. Furthermore, headline inflation measures have started to peak, due to energy price effects, which should in time help to relieve the pressure on real incomes, adding support to consumption.
While our view remains constructive in the shorter term, we can envisage being more cautious further out. We remain modestly overweight in risk assets and have not made any meaningful changes to portfolios. 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. However, we also 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. Furthermore, 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. We expect this comfort blanket to be tested more by investors in the second half of the year, particularly as we pass through the electoral cycle in Europe. Overall, we are maintaining our positive view in the shorter term but expect to be more cautious as the year progresses.
Equities: Notwithstanding the generally supportive backdrop, 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 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 to specific sectors. We are maintaining our overweight positions in European and Japan, which favour our pro-cyclical stance. In Japan, we have taken some exposure to small- and mid-cap Japanese equities in our higher risk strategies. UK equity remains an underweight position and we believe it is still too soon to repatriate assets. However, to mitigate the risk of a further bounce in sterling, we are slight re-orientating our UK equity position towards more exposure to mid-caps. The resilience of emerging market equities has been impressive and suggests a more positive outlook in the absence of a trade shock out of the US. However, we do not want to chase performance from here, already having a reasonable exposure to this asset class.
Bonds: Over the last month, bonds have benefitted from elevated geopolitical tensions and softer inflation expectations. We do not believe the downward trend in yields is being driven by a deteriorating growth backdrop and therefore do not see durability in this trend. Furthermore, investor positioning is less of a headwind to higher yields than it was six months ago. Given the Fed’s more hawkish tone, albeit at the margin, as well as more focus on an ECB exit strategy, we continue to believe that being short duration 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 property developers and listed vehicles continue to perform well, supported by better than expected fourth quarter results and the fall in UK gilt yields. Nonetheless, there are few catalysts that we can see in the shorter term, given supply concerns and uncertainty around Brexit, and we retain our underweight position. On a regional basis, we are primarily invested in cities outside of London, which are less exposed to ‘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: Notwithstanding the recent slide in the oil price, we continue to expect that an improving global economic environment and a tighter supply/demand balance will ultimately be supportive to commodity prices later 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. Despite its recent pullback, we maintain our position in gold as we continue to see it as a vital diversifier. Industrial/base metals have been weak, despite positive data surprises from China. Any further weakness may provide an opportunity to add.
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 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.