Markets may have recovered from the first volatile quarter of 2016, but what is next in store? This outlook aims to provide a view on how we see events unfolding and what our response as portfolio managers may be.
The market horrors of January and February have largely dissipated: deflation and recession fears looked misplaced to us then, and the market has reverted to a more sanguine view. Economic data and leading indicators have been robust enough to show up the January sell off as an unjustified panic, but perhaps not yet strong enough to give a clear signal that the economy is accelerating and enjoying the benefits of cheaper oil prices. Markets are in something of a holding pattern, looking for direction.
This looks a helpful environment for riskier debt, especially where pricing became severely dislocated in Q1. High yield bonds – and less liquid loans and structured credit – were discounting a severe and drawn out recession. While pricing has recovered somewhat through March and April, good value can still be found. Prospective returns look attractive, with high yields on offer and the possibility of some capital growth if excess credit spreads narrow to factor in a less downbeat view of the economy.
Equities have recovered somewhat from the pain in early 2016 and can make further ground, but valuations are critical. US companies have seen a strong recovery in profits since the 2009 lows, and profits broadly continue to look reasonably healthy when we take account of the drag from a strong US Dollar and the collapse in profits from energy companies: these factors will pass. But while we may feel reasonably optimistic about the US economy and the profit outlook, a degree of optimism is already reflected in US equity valuations, which do not look cheap relative to history. Stocks in much of Asia, including both China and Japan, do look very cheap relative to history: profit growth may be rather sluggish, but there’s no optimism priced in here. As the headwinds of weak commodity prices and a strong US Dollar fade and base effects kick in, the conditions are there for markets to be wrong-footed on inflation.
Europe comes into particular focus: signs of recovery in corporate profits since 2009 have been repeatedly snuffed out – first by a double-dip recession and the peripheral Eurozone crisis, then by the recovery in the Euro as a headwind to exports and foreign profits, and latterly by the collapse in energy sector profits and a squeeze on bank net interest margins. As a result, expected annual profits for large-cap Eurozone stocks are barely above Lehman crisis lows: an extraordinary situation. If one believes that Eurozone companies are broken, and profitability permanently impaired, European stocks are clearly too expensive; on the other hand, if one believes that the series of profit headwinds will pass and that profits can normalise over time, higher valuations are reasonable. We lean to the latter view – the series of specific headwinds to a profit recovery has been damaging, but is not permanent. It’s clear that the market’s patience has been severely tested and stocks will be volatile if investors lose reasons to expect profits to recover.
Markets worried about deflation earlier in the year: perhaps unsurprising, as weak energy prices dragged headline inflation to very low levels in many economies. But energy prices are volatile and their impact on inflation can be transient. While markets were worrying about deflation and speculating that the Fed’s next move could be to cut interest rates, core measures of inflation (which exclude energy and food) have actually been pushing higher, and a range of indicators suggest inflation pressures continue to build. Wages – a major component of services inflation – are rising and the combined effects of minimum wage hikes and tight labour markets suggest they will continue to do so; tenant demand for housing is pushing rents higher and healthcare costs are also rising. These are both big factors in the US Consumer Price Index (CPI) figures.
As the headwinds of weak commodity prices and a strong US Dollar fade and base effects kick in, the conditions are there for markets to be wrong-footed on inflation. While headline inflation today has been dragged lower by weak oil prices, inflation markets have extrapolated today’s oil price effects on inflation over the next 30 years: this seems unwarranted, and we’d expect it to reverse. With a high probability of US headline inflation readings later in 2016 rebounding quite meaningfully, this is not only a risk we can protect against cheaply, but an opportunity we can try to exploit. Gold, equities, property all play a role, alongside more targeted inflation protection contracts.
The BREXIT referendum remains an important factor. We already see some effects from referendum-related uncertainty in economic indicators, for example in corporate capital spending intentions and in London housebuyer enquiries. The ‘Remain’ camp seem to be holding a small but firm lead as we write, and this has seen some of Pound’s previous weakness dissipate. Markets appear to regard the Pound as the principal area of vulnerability in the event of a vote to ‘Leave’ the EU. The UK’s large current account deficit leaves the UK reliant on capital inflows, which may be at risk in an environment of political and economic uncertainty.
Although the polls and bookmakers’ odds suggest that a ‘Remain’ outcome is the most likely, events over the next six weeks may yet have a bearing, and the outcome – in terms of market impact – looks very asymmetrical: a vote to stay could see a modest Pound rally, but a vote to exit could see both significant Pound weakness* and the potential for volatility across a range of other risky assets. Even if ‘Remain’ still appears the most likely result, it is prudent to build some protection against a less probable, but potentially damaging alternative scenario. We maintain an underweight in Sterling as a hedge against the potential for meaningful weakness in the Pound if ‘Remain’s’ lead is threatened, with tilts towards the Euro, emerging market currencies and the US Dollar.
Deputy Chief Investment Officer
*The independent National Institute of Economic and Social Research has estimated that the Pound could fall by 20% on a BREXIT vote (10 May 2016).
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