At first glance, there’s a lot to like about the investment landscape as we look ahead. After a year of synchronised growth across the major global economies in 2017, with most growing above trend, economic momentum looks good and forecasters are expecting a continued healthy pace of growth in 2018; perhaps slightly slower than 2017’s excellent outturn, but very respectable by recent standards. Growth looks to be quite broad-based, not just across countries and regions of the world, but also across sectors of the economy. Meanwhile, households are enjoying the fruits of a stronger labour market, wages are ticking higher, consumer confidence looks healthy, and companies are generally reporting high levels of confidence about their business outlook as well as their plans for hiring and capital investment. That’s a supportive environment for corporate profits, and although analysts’ corporate earnings estimates are almost always too high, we have a greater degree of confidence than usual that corporate earnings can come close to the levels that analysts are currently forecasting.
Some observers are voicing concerns that the business cycle is well advanced and that we must therefore be close to the end, and to the next big bear market. We, however, see little evidence to support this given that the US expansion cycle, around eight years after the recession ended, has been significantly longer than average. And that’s no great surprise after an unusually deep slowdown and several tentative phases in the recovery.
Other signals of recession and a bear market are also largely absent: we’ve seen little of the behaviour we’d normally associate with such times.
In Europe, the expansion has been much shorter and did not get going until later since the Eurozone slipped into its double dip recession following the peripheral crisis. The passage of time and the calendar weighing heavy are not enough to justify a forecast of recession. Other signals of recession and a bear market are also largely absent: we’ve seen little of the behaviour we’d normally associate with such times. So there has been no sharp ramp up in corporate capital spending or mergers and acquisitions, no excess run up in corporate profits, and no blow out in credit markets. Meanwhile, there have also been no signs of investor euphoria (at least outside the niche of cryptocurrencies), no weakening of corporate confidence surveys, and while the yield curve – one of the best indicators of impending economic slowdown – has flattened somewhat over the last year, it is still some way from an ‘inversion’, where shorter-dated bonds yield higher than longer-dated bonds – a scenario that has preceded every other US recession in the last few decades. We may be in the later stages of an unusually long growth cycle, but there’s little to suggest that the end is imminent.
The more certainty companies have that the ultimate trading arrangements will differ little from the status quo, the more confidence we can have in the business investment outlook for the UK.
The UK, of course, faces different challenges as the Brexit negotiations continue. Consumer confidence has suffered and real wages have fallen. Sterling’s fall in value in 2016 led to a increase in inflation; and corporate confidence is less robust than elsewhere as companies still face uncertainty over the UK’s future trading relationship with the EU. The ease with which goods and services can be provided to European customers – allowing for supply chains to be managed efficiently across a new UK-EU border and the ability to recruit staff freely from across the continent – has a bearing on companies’ decisions about where to invest. The uncertainty will delay some decisions, cause others to be cancelled and may persuade some companies to implement contingency plans for fear of what might happen if the hoped-for exit deal does not hold. It’s not yet clear if the promised opportunities of future non-EU trade deals are driving companies to invest in the UK. Meanwhile, perhaps the uncertainty is fading a little; we have often talked about a ‘Hard Road to Soft Brexit’ as our central scenario, believing that economic headwinds and political realities would force the government to cross previous red lines and soften its position. This scenario seems increasingly likely and it’s an important case for investors. The more certainty companies have that the ultimate trading arrangements will differ little from the status quo, the more confidence we can have in the business investment outlook for the UK. This is vital both for the UK’s long term growth prospects and as an underpinning for the Pound. The destination is not yet defined, but the direction of travel appears increasingly clear.
On the face of it, the global growth environment should be one in which risk can be rewarded. However, we see several factors that keep us to a slightly more wary stance in portfolios – some economic-related, others concerning markets themselves. Although we suspect that global growth can still deliver positively in 2018, there are clear headwinds that could derail growth.
Firstly, China is already experiencing a slowdown in its growth rate, as policymakers have tried to curb excessive froth in the housing market and to foster a more balanced economy. There is a greater emphasis being placed on sustainability versus on growth at all costs. There is clearly scope for a Chinese economic slowdown to dip a little deeper than investors currently expect, and the consequences would spread through global supply chains – particularly in commodities and natural resources, where China is a key consumer. We have seen before how China scares can ripple across markets, even without significant real economic impacts. While the China slowdown scenario that we have modelled for 2018 has only moderate market and economic impact, there’s clearly a risk of something worse happening. And there are always China doom-mongers ready to seize on any sign of weakness.
Secondly there’s a distinct economic challenge that looks likely to figure in investors’ thinking in 2018 in the return of inflation, globally. There are already signs of this. Commodity prices have rebounded significantly from their 2016 lows and there’s evidence of inflation in supply chains, with US producer price inflation creeping higher, and edging above expectations. Wage pressures are building as unemployment falls, and market inflation expectations have risen through the second half of the year in both the US and Europe. A significant tax stimulus in the US could give added thrust to this dynamic. So far, markets have digested central bank tightening – rate hikes in the US, the first stages of tapering quantitative easing in Europe – rather well. However, if investors start to see a less benign balance between growth and inflation, markets could start to price in a more aggressive tightening from central banks, and potentially destabilise both bonds and equities.
While there are certainly still some areas of relatively good value, many markets are priced expensively relative to historic averages.
Last, but not least, our other concern centres on markets themselves. While there are certainly still some areas of relatively good value, many markets are priced expensively relative to historic averages. And while they are not necessarily at extraordinary or bubble-like levels, they are certainly at levels where we are forced to think more critically about the trade-offs of risk and reward. We also see markets experiencing extraordinarily low levels of volatility, extending an unusually long period with no significant correction or indeed any meaningful fluctuations. On some measures, this is the least volatile equity environment for 50 years. While there’s no immediate reason to suspect a change, we may reasonably suspect that nothing lasts forever, and that a transition to more normal volatility (perhaps prompted by central bank action or by a China scare), taking place against the backdrop of elevated market valuations, could justify a fall. If today’s low volatility has encouraged complacency and led some investors to take a little more risk than usual, a modest bump in markets could drive a recalibration of investors’ thinking on risk and develop into something more significant. We may have to wait a while for such an event, but hope to be well-placed should it happen. In the meantime, the low volatility means that downside protection, in the form of equity index put options, are relatively cheap. And it’s always worth taking out some insurance while the sun is shining.
So how does this affect our portfolio positioning? We maintain our slightly cautious attitude to equity, seeking a balance between some participation if markets continue to rise while looking for downside protection if the wind changes. We also continue to favour cheaper assets (in Europe in particular) and are adding back an allocation of a-little-too-cheap UK equity assets for the first time in many months. This has been funded by taking profits on some moderately risky investments, such as high yield bonds and some alternatives. We also continue to hold a healthy cash balance, which we stand ready to deploy if volatility increases. And we have been adjusting our tail risk hedges, replacing some gold with more targeted equity downside protection.
Deputy Chief Investment Officer
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