By John Stopford
At a glance
- The current bull market in Growth assets is intact, but vulnerabilities are increasing
- We have begun to reduce risk, seeking attractive opportunities from the bottom-up
- Current positioning:
- Cyclical and financial equities look relatively attractive
- Corporate bonds require being cautiously selective
- Government bonds have supportive long-term drivers but cyclical challenges remain
- The Japanese yen offers Defensive characteristics and support for the dollar is likely to fade
- We are closely monitoring the market reaction to the withdrawal of central bank monetary easing
The bull market for Growth assets such as equities and high yield corporate bonds is maturing, with increasingly stretched valuations. While valuations alone rarely cause markets to reverse, they imply lower longer-term returns. Bull markets typically only end just before an economic downturn and after a prolonged period of tighter liquidity conditions, neither of which are yet evident. The risk of recession appears low, monetary conditions are loose and growth momentum is strong.
Market price behaviour is still risk-seeking. Flows from passive investments could even cause a final ‘melt-up’ in stock prices as investor scepticism potentially gives way to late cycle euphoria.
…but vulnerabilities increasing
However, the fundamental backdrop is slowly weakening. Global economic growth has used up much of the spare capacity available for above-trend growth. At the same time, monetary policy looks likely to become steadily less supportive. The Trump tax reduction plan could spark a classic end to the current business cycle, creating a boom followed by a bust. Cutting taxes with unemployment at its current lows would boost growth, but should also push up inflation expectations and risk in the bond market.
Figure 1: G7 GDP growth vs. trend
Source: Investec Asset Management, as at 31.10.17.
Portfolio positioning – Incrementally less risk
The cost of being a little early in getting out of the market is similar historically to being a bit late. Many talented investors have already missed much of this bull market by being bearish too soon, and this could remain the case if the business cycle is extended. We believe the right approach is to run incrementally less risk within our allowed risk budget, but to keep some exposure to Growth assets given the probability of further market strength.
We build portfolios from the bottom-up, which allows us to find securities which offer an attractive combination of yield, sustainable income generation and potential for rising prices.
Equities – Opportunities in cyclicals and financials
Within equities, we are finding interesting opportunities in financial and cyclical stocks, which tend to benefit from an improved economic backdrop and are less sensitive to volatile bond yields. From a regional perspective, valuations and cyclical momentum appear better outside the US, but the US still contains many great companies and may see additional upside if the proposed tax cuts are passed.
Corporate bonds – Cautiously selective
We are cautious towards corporate bonds. However, we do see selective opportunities in emerging markets, which typically offer more value than their developed market peers and are better supported by the higher economic growth. We are still cautious, however, due to a number of idiosyncratic risks – investor flows into the asset class remain lumpy, driving bouts of volatility.
Government bonds – Long-term drivers still in place
The factors that have driven government bond yields down over the last 35 years remain largely in place, particularly inflationary forces and the causes of muted growth. This makes us buyers of long-dated US Treasuries if we see further price weakness.
Figure 2: Global equities vs. US Treasury yields
Source: Bloomberg, as at 30.09.17.
However, we still see the risk of higher yields in the near term, due to less central bank bond buying, a probable pick-up in core inflation next year and the potential for fiscal easing in the US. Any of these factors could push up real and nominal yields, even if slower trend growth and secular disinflationary forces are tending still to pull bond yields in the opposite direction.
We prefer bonds from issuers where the economies are unlikely to be able to tolerate the high interest rates that many investors expect, such as Canada and Australia. We also see value in being short long-dated Japanese government bonds, as a hedge against higher yields globally.
Currencies – Defensive yen, fading the dollar
We own the Japanese yen as a Defensive position. As a global lender, Japan is an exporter of capital. In a crisis, we believe the yen would climb as capital tends to stay at or return home. The currency also appears cheap and would probably rally on any further softening of the Bank of Japan’s expansionary monetary policy.
In our view, the US dollar bull market may be over after six years of real appreciation against major trading partners. Previous up cycles in the currency have lasted slightly longer, but have then been followed by long periods of underperformance. The dollar may, however, stabilise, or recover temporarily in the short term, before resuming a downward trend, given how far sentiment has already shifted in the last year – investors are becoming much more optimistic about Europe than the US.
Risk beyond the bust
The main market risk is always the possibility of recession. However, beyond this our concerns are focused on how well markets, fuelled in part by liquidity, will deal with a reduction of central bank bond buying. We also worry whether or not China can successfully transition to a growth model driven less by debt.
Other important risks are largely geopolitical and include further political instability in Europe, the potential for a hard Brexit, the chance of a follow through on Trump’s protectionist rhetoric, and rising tensions with North Korea and Iran.
Our focus on downside risks suggests we should be aware of and manage the potential consequences of these risks. We will look to quickly scale back exposure if the market environment starts to deteriorate.
One final rally?
With no immediate sign of an economic slowdown, the current market looks like it may have life to it yet. Investors are still seeking risk and the bull market could attract further passive flows and a late-cycle buying spree.
But it is certainly beginning to show its age with valuations looking stretched in places, a global economy with less slack for further above-trend growth and central banks looking to withdraw monetary support. A prudent response is to selectively and incrementally reduce risk in the portfolio.
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