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Despite investor concerns about political and geo-political threats, the economic and corporate profits cycle remains supportive for risk assets.
It has been a challenging first half of the year as investor confidence has taken a hit for a number of reasons. However, over a Tactical Asset Allocation (TAA) time horizon, up to 12 months, we remain convinced that the environment is one that will ultimately reward a ‘risk-on’ investment stance. The problem is that three issues have clouded investors’ minds, namely the sustainability of growth and profits, geopolitics, and US-led trade protectionism, and the latter two are expected to remain a feature of the investment landscape for some time. Given this backdrop, the most sensible strategy is to remain ‘pro-risk’, but incorporate a number of hedges to mitigate against adverse scenarios, without materially constraining performance should these risks fail to materialise.
This is the first article about our model portfolio approach since the integration of the TAA teams of Standard Life Investments and Aberdeen Asset Management into the Aberdeen Standard Investments’ Global Strategy team. We have taken the opportunity to review our contribution to Global Outlook, so that the evolution of our analysis improves the clarity of our message. While our research and decision-making processes are unchanged, several points are worth highlighting. Firstly, our top-down macro-driven research process, supported by the bottom-up insights of colleagues in specialist investment teams, still sits at the heart of view formulation. Second, we continue to think of market prices being influenced by a combination of four important drivers: the macro-profit outlook, monetary factors, valuation and behavioural elements. Third, a strong emphasis on intelligent portfolio construction remains in place, sensibly looking for ways to hedge our strategy against potentially adverse outcomes.
Following January’s sudden equity market sell-off, a combination of weaker than expected macro-economic data outside of the US (Continental Europe and Japan in particular), geopolitical events (for example North Korea and more recently Italy), and policy concerns (primarily centred around President Trump’s trade sanctions) have served to cap the recovery in stock prices.
We have debated the outlook for global growth both within our team and across the firm, and the view remains: for the next twelve to eighteen months, activity will remain at, or above, trend in the majority of the large economies, supported by a broad- based improvement in investment, further increases in employment and nominal incomes, and healthier banking systems. However, growth will be less synchronised than it was in 2017 for a number of reasons:
1) The impact of the US fiscal stimulus will primarily benefit the domestic US economy, while forcing the Fed into a faster pace of policy adjustment and generating negative spill-over effects for foreign economies through tighter dollar liquidity conditions;
2) The large increase in oil prices is redistributing income and activity away from oil importing economies to oil producers, and from consumption to investment;
3) The less accommodative stance of Chinese policy will lead to a further moderation in domestic activity while weighing on activity in those developed and emerging economies most affected by the Chinese cycle;
4) The natural slowdown in the Eurozone and Japanese economies from their unsustainably rapid growth in the second half of 2017.
This positive backdrop, accompanied by only a modest increase in core inflation, may deliver high single digit global corporate profit growth in 2018 and at least the first half of 2019. Pressures on company margins are appearing in a few US sectors – transport is an example - but are generally expected to be manageable. This reflects the benefits of tax cuts and stronger productivity growth from business investment, as well as the lack of wages pressures in other economies.
The geopolitical and policy backdrop will remain challenging and tilt global growth risks to the downside
However, the geopolitical and policy backdrop will remain challenging and tilt global growth risks to the downside. The recent protectionist turn in trade policy is of most concern here. Although tariffs and policy measures put in place so far have been modest from a macroeconomic perspective, they undermine the rules-based global trade system and raise uncertainty about the future. This has the potential to undermine the upswing in global business investment and lead investors to demand a higher premium to hold risky assets. A second issue to consider is the interaction of fiscal and monetary policy. Although the global monetary policy cycle is expected to turn only slowly outside the US, restrained by muted inflation pressures, the late cycle US fiscal stimulus increases the risk of overheating, and hence raises the medium-term risks to global economic expansion. Indeed, even if these risks do not actually materialise, there remains a chance that less confident investors choose, from time to time, to discount them.
This leads to questions around other potential sources of economic and equity market vulnerability. A good example is Emerging Markets, where the recent appreciation of the dollar has led to a reversal in capital flows, with especially large effects in those economies like Argentina and Turkey considered to be the most fragile. However, even economies with a favourable external balance profile like India and Indonesia have been forced to tighten monetary policy recently. Nevertheless, our judgement is that aggregate EM growth will remain solid, though unspectacular by historical standards, while systemic risks appear contained by more robust balance sheets. Nonetheless, it is reasonable to expect short bursts of moderate financial market volatility as we enter the later stage of the current global economic cycle.
Given the cyclical backdrop, our valuation framework shows a normal relationship between equities and bonds, with similar findings for credit spreads and the dollar. When looked at through the prism of growth and what’s priced in for the cycle, asset classes are pricing in the current environment quite appropriately. Equities have de-rated enough to price in the likely more moderate growth this year, and may have overshot on the downside. Credit spreads are wider, consistent with a general slowing in growth expectations, and notably this does not appear to be EM specific. Dollar strength is not independent of the previous two observations: the currency appears to be largely driven by growth divergence rather than bond spreads, so is behaving normally as well. The fact that EM currencies are moving pretty much lock step with the trade-weighted US dollar suggests this is part of the global growth repricing rather than anything more.
The risk of trade wars has been discounted to some extent, as evidenced by the performance of equity markets and sectors
The risk of trade wars has been discounted to some extent, as evidenced by the performance of equity markets and sectors. For example EM, Japan and Germany (markets with a large proportion of profits sourced from overseas) have sharply underperformed global equities over the past two months. Similarly materials, industrials, technology and autos have underperformed over the past month. While President Trump is unlikely to ease the pressure on trading partners prior to the mid-term elections, some moderation in rhetoric is possible thereafter should common sense prevail, which should allow investors to refocus their attention on supportive equity market fundamentals.
We should not forget the behavioural dimension of investment. Recent equity market performance needs to be put into the context of what happened in late 2017: a period of exuberance exemplified by a surge in equity prices during the fourth quarter. Not surprisingly, following a sharp correction a period of consolidation has followed, as some investors have had to revise their expectations downward and unwind inappropriately bullish investment positions. Having signalled ‘sell’ in mid-January, our short term timing indicator is back in ‘buy’ territory. However, our medium-term timing indicator has only dropped to ‘neutral’, although it is closer to ‘buy’ than ‘sell’.
Compared to our positioning a few months ago, we have used the weakness in equity markets during the first half of the year to add to our overweight stance. As bond yields have risen, we have bought high quality government bonds (via US TIPs), eliminating an underweight stance. The offset to these purchases has been a sale of investment grade corporate bonds and a modest reduction in our cash position. That means we enter the second half of 2018 with a significant equity overweight, complemented by a small property overweight (via Continental European REITS). We are funding these positions using underweight stances in both credit and cash. At the sub-asset class level, our equity market preferences reflect the attraction of cyclical markets such as EM, Japan and to a lesser extent Continental Europe, while introducing an overweight to the US earlier in the year.
Given macro, geopolitical and policy uncertainties, it makes sense to complement our ‘risk-on’ stance with a number of hedges. Our overweight in US TIPs is one of these, a position that should perform should economic growth disappoint; but the position could also do well should inflation surprise to the upside. Another diversifier is an overweight stance in Australian government bonds, which could outperform should Chinese growth disappoint. Holding EM assets funded out of Euros or non-US$ baskets is also part of this partial hedging strategy, as is our overweight exposure to the Japanese yen - a traditional safe haven currency. We continue to use a significant amount of our assigned risk budget, although there remains some room to add to it should there be sufficiently good reasons to do so.
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