Softening in Global Economic Momentum Continues

By Graham Bishop, Investment Director at Heartwood Investment Management

Our view of a slight softening in global economic momentum in the second half of the year remains unchanged, alongside our expectation of moderately rising inflation trends over coming months. Central banks are likely to continue on (or begin) their journey of normalising monetary policy, which we believe is a scenario that financial markets are not yet fully pricing. Risk appetite remains reasonably buoyant and market volatility very low, albeit there has been a moderate increase more recently on geopolitical concerns. We are mindful that the current benign fundamental backdrop of moderate growth, low interest rates and low inflation is leading to a certain amount of complacency in markets. Our concern is that any deterioration in the growth/inflation story could prompt profit-taking and challenge this more sanguine view of the world. We continue to believe that monetary policy remains a key trigger for caution, notwithstanding that central banks have stepped back from their hawkish signals provided in recent weeks. In our view, the risk/reward dynamic of risk assets is not as favourable compared with the start of the year and we believe it is appropriate to stay with our risk reduction plan. This will be focused on UK property, given potential liquidity issues in the event of any sell-off. Overall, we are taking a measured approach in reducing risk and maintaining flexibility to re-calibrate portfolios in either direction should economic and market conditions change.

Equities: Emerging market (EM) indices were particularly strong in July, boosted by the weak US dollar. US, UK and Asian indices have also put in respectable return. We are retaining our overweight in European equities for now, but we are more cautious about this market given very strong currency moves. Conversely, the weakness of the US dollar is a boost to the corporate sector, so we are happy to run our existing US equity weight (but still preferring a more targeted approach). We remain concerned about economic slowdown in the UK and broader policy backdrop (Bank of England, Brexit and domestic politics). We would not repatriate to the UK, nor would we increase domestic versus overseas UK equities right now. Elsewhere, we are comfortable with retaining our overweight positions in Japanese and EM equities.

Bonds: A less hawkish backdrop drove global bond yields lower in July. Rate expectations remain dovish and look most vulnerable to a re‐pricing in the US and Europe. Therefore, our caution towards maintaining a short duration position remains intact. Break-even rates (the difference between nominal fixed-rate bonds and the inflation-adjusted yield on an inflation-linked bond) are falling in the UK, but are recovering to some degree in the US and Europe, which is consistent with the fundamental backdrop. Credit spreads have been supported by the ‘goldilocks growth’ backdrop, and in some areas are back to or close to the tights in 2014.

Property: We have marginally reduced our UK property allocation further, comprising part of our risk reduction plan, as well as to address issues around investment trust premiums and liquidity withdrawal, given the maturity of the current cycle. We also believe an underweight stance is appropriate in light of UK political uncertainties. While activity has slowed and there are questions about rent sustainability, our regional bias and reasonable discounts on certain instruments will provide some protection in the event that market yields move higher. At this stage, there is no appetite to add overseas exposure.

Commodities: Markets were resilient in July, continuing the gains that began in mid‐June. Negative news about oil inventories has faded, although demand remains sluggish. We believe there is limited room for oil prices to go much higher from here, especially given rising output in Libya and with the end of OPEC supply cuts coming in the first quarter of 2018. Industrial metals have performed well, although this appears to be supply-driven rather than due to rising demand. Meanwhile, precious metals have been helped by US dollar weakness and lower real yields – factors which we think are unlikely to persist. We retain our underweight allocation in commodities, although we are maintaining our exposure to gold for portfolio diversification.

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.

By Graham Bishop, Investment Director at Heartwood Investment Management

Our view of a slight softening in global economic momentum in the second half of the year remains unchanged, alongside our expectation of moderately rising inflation trends over coming months. Central banks are likely to continue on (or begin) their journey of normalising monetary policy, which we believe is a scenario that financial markets are not yet fully pricing. Risk appetite remains reasonably buoyant and market volatility very low, albeit there has been a moderate increase more recently on geopolitical concerns. We are mindful that the current benign fundamental backdrop of moderate growth, low interest rates and low inflation is leading to a certain amount of complacency in markets. Our concern is that any deterioration in the growth/inflation story could prompt profit-taking and challenge this more sanguine view of the world. We continue to believe that monetary policy remains a key trigger for caution, notwithstanding that central banks have stepped back from their hawkish signals provided in recent weeks. In our view, the risk/reward dynamic of risk assets is not as favourable compared with the start of the year and we believe it is appropriate to stay with our risk reduction plan. This will be focused on UK property, given potential liquidity issues in the event of any sell-off. Overall, we are taking a measured approach in reducing risk and maintaining flexibility to re-calibrate portfolios in either direction should economic and market conditions change.

Equities: Emerging market (EM) indices were particularly strong in July, boosted by the weak US dollar. US, UK and Asian indices have also put in respectable return. We are retaining our overweight in European equities for now, but we are more cautious about this market given very strong currency moves. Conversely, the weakness of the US dollar is a boost to the corporate sector, so we are happy to run our existing US equity weight (but still preferring a more targeted approach). We remain concerned about economic slowdown in the UK and broader policy backdrop (Bank of England, Brexit and domestic politics). We would not repatriate to the UK, nor would we increase domestic versus overseas UK equities right now. Elsewhere, we are comfortable with retaining our overweight positions in Japanese and EM equities.

Bonds: A less hawkish backdrop drove global bond yields lower in July. Rate expectations remain dovish and look most vulnerable to a re‐pricing in the US and Europe. Therefore, our caution towards maintaining a short duration position remains intact. Break-even rates (the difference between nominal fixed-rate bonds and the inflation-adjusted yield on an inflation-linked bond) are falling in the UK, but are recovering to some degree in the US and Europe, which is consistent with the fundamental backdrop. Credit spreads have been supported by the ‘goldilocks growth’ backdrop, and in some areas are back to or close to the tights in 2014.

Property: We have marginally reduced our UK property allocation further, comprising part of our risk reduction plan, as well as to address issues around investment trust premiums and liquidity withdrawal, given the maturity of the current cycle. We also believe an underweight stance is appropriate in light of UK political uncertainties. While activity has slowed and there are questions about rent sustainability, our regional bias and reasonable discounts on certain instruments will provide some protection in the event that market yields move higher. At this stage, there is no appetite to add overseas exposure.

Commodities: Markets were resilient in July, continuing the gains that began in mid‐June. Negative news about oil inventories has faded, although demand remains sluggish. We believe there is limited room for oil prices to go much higher from here, especially given rising output in Libya and with the end of OPEC supply cuts coming in the first quarter of 2018. Industrial metals have performed well, although this appears to be supply-driven rather than due to rising demand. Meanwhile, precious metals have been helped by US dollar weakness and lower real yields – factors which we think are unlikely to persist. We retain our underweight allocation in commodities, although we are maintaining our exposure to gold for portfolio diversification.

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.