Markets remain skittish and seem to indicate that the world's economy is about to nose dive into recession. This outlook aims to provide a view on how we see events unfolding and what our response as portfolio managers may be.
The panic may be over for now, but investor sentiment remains skittish, with fears of a renewed bout of volatility buried not far under the surface. There may be little fundamental justification for this: corporate profit growth has been disappointing (to a large extent due to the collapse in commodity-sector profits) but the weight of data confirms that the US economic cycle continues, with signs of life re-emerging in manufacturing after the lull of the last few months. Central banks across the major economies continue to tilt policy towards growth and promoting credit, and subtly away from the beggar-thy-neighbour currency devaluation policies of the last few years. The European Central Bank (ECB) has eased further, with targeted measures to improve credit availability; the People’s Bank of China (PBoC) continues to implement fiscal and monetary support measures while improving its communication with markets on currency policy; and the Bank of Japan (BoJ) seems likely to attempt continued stimulus throughout April. Since their initial rate hike in December, the US Federal Reserve (Fed) has been at pains to calm markets about the likely pace of future rate rises.
Some investors are now fearful that loose monetary policy, at a time when the economic recovery continues, may be building a nasty inflation surprise. This is a risk worth guarding against: markets have been preoccupied with deflation risks in the early part of the year – only weeks ago, investors were speculating about the Fed cutting interest rates into negative territory to fight deflation. But with oil prices stabilising, employment increasing and wages rising, the risks to inflation could indeed be on the upside. Finding further protection at reasonable prices seems like a sensible precaution: inflation-linked bonds in the US are cheap relative to US Treasuries, pricing in inflation as low as 1.5% on average over the next decade – we have added to our positions. We have been wary of gold for several years, and have seen prices fall from around US$1900/oz in 2011 to around US$1200/oz now. Gold is seen as a solid hedge against unexpected inflation (and against unanticipated risks generally); in a world where cash yields zero and many government bonds offer negative yields, the opportunity cost of holding the yellow metal is low, and it can again play a role in the defensive side of our portfolios. We have made an allocation to gold in most portfolios.While relative calm reigns at present, we cannot be sure that such an environment will persist.
Markets have become quite focused on the implications of the UK’s forthcoming EU referendum, and this obsession will intensify further in the next couple of months. We continue to believe that currency markets will see the biggest impact from BREXIT fears. Sterling has already weakened markedly since the turn of the year, but this reflects deferred expectations of UK rate hikes as well as concerns over the referendum. The UK’s deep current account deficit leaves the Pound very vulnerable to uncertainty over trade and international investment flows. Leaving aside the politics, it seems plausible to us that a vote to leave the EU could result in significant Sterling weakness.
Holding a globally diversified portfolio, with meaningful allocations to the US Dollar, Euro and emerging market currencies, is a reasonable defence. But we should remain agile and prepared to reverse course: uncertainty between now and 23 June could undermine Sterling, but if the polls – currently predicting a tight victory for "Remain" – are correct, there could be considerable scope for a relief rally. We will be ready to act.
We are reassured to some extent by the progress of the global economy and the support that central banks continue to provide. However, we have seen again over the last year how markets can take a course that has little basis in the macro data. When fear takes hold, a little volatility can rapidly breed a lot more volatility. While relative calm reigns at present, we cannot be sure that such an environment will persist. The challenge then is to balance our aims to generate attractive long-term returns by investing in undervalued and sometimes unpopular asset classes, with the need to manage shorter-term volatility – at a time when traditional safe havens are unusually expensive and the investing environment can turn on a sixpence. The environment requires some resilience from investors – an acceptance that generating investment returns brings some volatility – but it also requires strong portfolio construction to manage a challenging combination of risks, and a nimble tactical approach, able to adjust exposures as markets move and the outlook evolves, ensuring that we have the scope to add to favoured assets when future bouts of market volatility inevitability create opportunities. Our portfolio moves in March / early April have reduced overall levels of risk, while retaining exposure to assets that still have strong potential to perform.
Deputy Chief Investment Officer
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