Investors face a potentially difficult balancing act today. There is much to be positive – even optimistic – about. Most major economies are growing at or above trend, and companies have been experiencing sound earnings’ growth.
Stockmarkets have generally celebrated in response, with global equities reaching new highs. However, this creates several issues for investors: valuation; whether the outlook is as robust as markets are hoping; and the behaviour of central banks.
As optimism has been baked into financial markets, valuations of risky assets have become more extended. There are exceptions – Europe, for example, has been de-rated recently despite evidence of increasingly resilient economic growth – but global equities are no longer cheap. In particular, US equities have not traded at such a high multiple to forecast earnings as today since the deflating of the technology bubble in the early 2000s. Emerging Market stocks (where the technology sector is an increasingly dominant force) have also traded to the highest valuations seen since the 2008 Financial Crisis. This may be justified by the rosy prospects for particularly disruptive businesses driving the indices higher, but we could be worried by the market’s quite narrow dependence on a handful of companies for the lion’s share of its growth. This is because over a third of the rise in US equities this year is due to the performance of half a dozen technology stocks. Over a third of the rise in US equities this year is due to the performance of half a dozen technology stocks.
We see a similar phenomenon in corporate bond markets too, where the additional yields on offer for lending to either risky or to better quality borrowers have fallen significantly – not quite to all-time lows, but within touching distance of levels seen in the credit boom of the mid-2000s. In combination with very low government bond yields, this leaves very little room for error. Unfortunately, high valuations are a fairly weak predictor of future market performance in the short term, where the power of positive momentum can overwhelm rational valuations. Valuations might make us expect expensive asset classes to generate lower than average returns over the medium term, but they should not make us overly confident that a correction is imminent; often, another catalyst would be needed.
Might we see such a catalyst from growth disappointments – perhaps emanating from China or the US? It seems highly likely that China’s growth will slow, after a recent policy-induced pickup in activity. The authorities have been clamping down on mortgage lending and seem to be putting more emphasis on stability than on growth in their policy decisions. As long as any slowdown in growth is gradual, and the economy remains sensitive to policymakers’ attempts to fine tune, then any impact should be minimal. However, if a slowdown is more pronounced, the ripples will be felt globally – first, perhaps, among Emerging Market commodity exporters and through industries such as capital goods. We don’t currently put a high probability on this scenario, but it can’t be dismissed, and it would support an investor rotation back out of risky assets (particularly Emerging Markets) into safe havens, like US Treasuries. Unfortunately, high valuations are a fairly weak predictor of future market performance in the short term.
Perhaps the US could disappoint? After all, despite falling unemployment, wages haven’t really picked up as strongly as one would expect, and consumer spending hasn’t cut loose. Hopes of a government-led stimulus have fallen by the wayside as the chaos and divisiveness of the Trump administration has stymied attempts to take new measures through Congress. And while the US economy benefitted through much of 2016 from lower energy prices (effectively increasing disposable incomes), that boost has faded now and gasoline prices are rising again. The Federal Reserve under Janet Yellen has been raising interest rates and has just strongly signalled another hike for December, and a firm intention to keep raising rates through 2018. Could it be that the US recovery is not on such firm foundations as investors had hoped? Have expectations become far too optimistic, building in scope for future disappointment? This is not our most likely scenario, but again we must take this threat seriously. Sadly the devastation caused by the wave of hurricanes around the Gulf Coast will make it hard to read the progress of the US economy over the next couple of months. It’s not impossible that markets could misinterpret data disrupted by the hurricanes as evidence of a more profound slowdown.
Let’s be clear: we still see a decent probability that the global economy continues on its expansionary path, which would be broadly supportive for risky assets such as equities. We might expect some volatility around this if there’s enough inflation to push central banks into more aggressive tightening – running down their Quantitative Easing policies and increasing interest rates more quickly than the market currently expects – but still with a positive bias. However, the balance between risk and reward is always shifting. So compared to three or six months ago, we now see a little less upside if the economy stays on a positive path and a little more downside if growth slows. After a recent upsurge, Emerging Market equities look a little more vulnerable (especially if the US Dollar rallies), and perhaps ripe for profit-taking. Meanwhile, Japan and European equities look less vulnerable – Europe in particular, as markets there have recently underperformed and valuations have improved. The Eurozone economy looks unusually robust, but that strength has played out more in supporting the currency, less so in the equity market, perhaps opening a window for performance if the currency stops surging.We still see a decent probability that the global economy continues on its expansionary path.
This column usually has something to say about Brexit. We’ll hold most of our fire for the September review in a couple of weeks’ time. Suffice to say that the ‘Hard Road to Soft Brexit’ scenario we laid out at the start of the year seems to have some merit. As the economy slows, as the extent of the task facing UK policymakers in preparing for life outside the EU institutions, and the scale of damage to trade and investment that could be wrought by exit becomes clearer, as political constraints around the government and May’s weak Parliamentary position make contact with the reality of the EU’s unified stance and the ticking clock of Article 50’s two year countdown, the UK government’s position could change. Views on a transitional period, a financial settlement, "No Deal" versus a "Bad Deal", citizens’ rights, and even on the future role of the European Court of Justice appear to be marginally softening. Labour’s position on crucial aspects such as membership of the Single Market and a Customs Union with EU softening may be ahead of the government’s. The Pound has seemed more sensitive to perceptions of where UK interest rates may go – perhaps ill-advisedly, as the justification for a rate hike seems quite weak. But the gradual softening of the Brexit policy provides support in the background. We retain significant exposure to Sterling, augmented by options strategies designed to pay off if the Pound rallies sharply against the US Dollar – as it might in a more fundamental political shift over Brexit.
Suffice to say that the ‘Hard Road to Soft Brexit’ scenario we laid out at the start of the year seems to have some merit.
Overall, we are cautious in our positioning but not overly so: underweight equity, but focussed on markets like Europe and Japan, which offer more attractive valuations and cyclical exposure, although these can be volatile. So we also hold safe havens like Gold and US Treasuries, but are leaning away from Gilts given extremely low yields, and still holding a meaningful weight in riskier bonds such as Emerging Markets and pockets of corporate credit. We hold plenty of cash, giving us flexibility to add to other asset positions if markets do fall, but are some way below our highest ever levels – thanks in part to recent additions to some alternative strategies. Looking at asset allocation alone, we are taking a little less risk than usual; looking at currency, we are taking a lot less risk than usual, with a significant tilt towards the Pound – a protective measure against the possibility of Sterling rebounding.
Deputy Chief Investment Officer
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