The global economy remains robust with little risk of recession anticipated by our models over the next 12 – 18 months. Meanwhile, improving economic data have provided the impetus for global equities to extend their performance. Although the recovery in emerging market economies has not been as strong - they have beaten expectations. In turn, this has benefited assets tied to these markets.
Figure 1. Is there a recession coming?
Source: Investec Asset Management, NEBR as at 31 August 2017
Many companies have underinvested in capital expenditure, using their cash instead to buy back shares. This has led to low productivity which, in turn, has made companies reluctant to raise wages. Although low inflation, due in part to weak wage growth, remains a concern for central banks, the perceived risk of low interest rates is beginning to outweigh the benefits. Consequently, there is now a bias to tighten policy gradually, with the US leading the way. The normalisation of quantitative easing (QE) is a widely recognised risk to markets and will be watched closely for its impact on assets. However, this does create opportunities where market expectations of rate hikes move too far ahead, such as in the UK and Canada.
Within equity markets, the most cyclical sectors have beaten revenue and earnings expectations by the greatest margin over the last year. We continue to like more cyclical areas of the equity market, including Japan and the railways sub-sector within transportation stocks. Within Japan, we prefer companies with strong or improving corporate governance which are either committed to improving total shareholder returns through higher dividends and buybacks or that have a strong restructuring story. The market continues to reward these companies, and the Japanese market remains cheap on a global basis.
The yen is also very attractive on a global basis, especially considering the robust fundamentals in the Japanese economy. For much of the past decade, the performance of these two asset classes have offset one another, but this relationship has de-coupled so far this year and we expect this to continue.
Figure 2: Japanese Equities - Breaking the currency link
Source: Bloomberg as at 30 September 2017
With central banks beginning to slow, or unwind, quantitative easing, it is reasonable to question why we own Defensive government bonds and whether their relationship to Growth assets will change. Our view is that these government bonds will retain their diversification properties. This is principally because there remains very little risk from inflation due to deleveraging, an ageing demographic profile and low productivity. In the US, we have therefore focused our exposure on the very long end of the bond market. Meanwhile, we are closely analysing the potential for a shift in correlation between bonds and equities.
Although the fundamental outlook appears robust, with China providing a tailwind, we recognise that the valuations of many asset classes look expensive. Despite this, positioning is not extended and there is a reasonable likelihood that the market ‘melts up’ from here. Against this backdrop, we shall continue to find opportunities. Among equities, for example, we like mining companies since after a long earnings recession following the financial crisis, some companies now offer high dividend yields underpinned by greater capital discipline. However, we consider it important to be selective as the risk/reward offered by markets is no longer as attractive as it was even a few months ago.
In our view, this is not a time to be running for cover, but it is important to ensure investors are adequately compensated for risk and we continue to layer in protection as markets move upwards.
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