The following reflects the views of Philip Saunders, co-head of Multi-Asset at Investec Asset Management, as at 19 February 2018.
While we recognise that we are in a mature phase of the current bull market – at least as far as developed markets are concerned - we think that recent weakness represents an opportunity to restore equity exposure to preferred allocations.
This cycle has seen a number of ‘panic attacks’ which have seen sharp but short run corrections associated with episodic spikes in volatility from low levels. The recent sell off would appear to fit with this pattern, as evidenced in the lack of cross asset class contagion, the lack of rotation in sector leadership in equity markets, continued strong underlying economic activity and dynamic earnings and finally supportive financial conditions, as evidenced by renewed Dollar weakness.
What had been threatening to evolve into a ‘melt up’ environment not dissimilar to 1987 has, for now, probably been arrested.
Will sharply rising inflation pressures accelerate the tightening of monetary conditions?
While some cyclical pressure on inflation rates is to be expected, especially in the United States, where the recovery is mature, unemployment levels low and fiscal policy in the process of being loosened, we tend to lean against the more pronounced concerns about a regime shift, but recognise that cyclical pressures could re-assert themselves. For now, however, bond markets have over reacted and are heavily oversold, consequently the chance of a ‘bear squeeze’ is high in the near term.
US 10 Year futures net LONG/SHORT positions vs futures price
Source: Longview Economics, Macrobond
From a more strategic perspective it should be recognised that financial conditions are on a tightening trend internationally, with the Bank of Japan and the ECB rightly expected to be moving away from QE and the super loose monetary conditions associated with it. Tailwinds for asset prices will eventually turn to headwinds.
Central bank buying vs index returns
Source: Investec Asset Management, Central Banks & IMF, MSCI & Barclays Index data, December 2017.
Volatility should be expected to rise
Although market volatility should continue to moderate from the recent highs, it tends to rise in the later stages of cycles. Indeed, many of the factors that have suppressed volatility in the current cycle are ebbing and the recent spike in equity volatility probably marks an important inflection point in this regard.
Volatility tends to rise at this point in the cycle
Source: Investec Asset Management, Bloomberg
Why is the Dollar weakening?
Dollar weakness has come as a surprise to many market participants who were assuming that accelerating growth in the United States would be associated with widening interest rate differentials in that currency’s favour. Expectations that the Dollar would behave defensively in a risk off environment proved to be misplaced. The currency had a modest bounce before selling off. We think that the key inflection point occurred in early 2016 and that the Dollar remains in a medium term bear market which has further to run. This has more to do with the ex US recovery, longer term investor positioning and, more recently, fiscal laxity, than simplistic interest rate differentials.
Of the major currencies we continue to favour the Yen which remains undervalued and tends to possess reliable defensive qualities.
The Yen is cheap and the Japanese economy is booming
Source: Investec Asset Management, Bloomberg. BEER = Terms of trade (relative prices of exports to imports); FEER = Fundamental effective exchange rates (current account based measure); PPP = Purchasing power parity (standardised goods prices based measure)
Which regions should investors prefer?
Although in our view both the Japanese and European equity markets offer attractive valuations and earnings head room the appreciation of their respective currencies represent headwinds. Dollar centric investors should favour active over passive approaches and consider running such positions partly or wholly unhedged. Emerging markets, especially Asia, are likely to be impacted less by Dollar weakness and their recoveries are at an earlier stage. After protracted periods of muted demand, operational leverage is high and we feel not yet adequately reflected in valuations.
Asia ex-Japan corporate free cash flow has been improving
(Cash margins (FCF/Sales) by sector MSCI Asia
Source: FactSet, CLSA, 30 June 2017.
A softer Dollar is likely to be supportive, benefitting commodity prices. From a bottom up perspective China, especially ‘old China’, continues to stand out as offering some of the best value opportunities across emerging markets.
The rate of growth in debt in China is slowing as SOE capital productivity improves
Source: PBOC, NBS, J.P. Morgan
Local currency emerging debt should also benefit from a softer Dollar environment, although valuations have become less attractive in an absolute sense.
Which sectors should investors prefer?
In general terms we believe that we remain in a market environment characterised by momentum and cyclical recovery leading us to continue to favour the more cyclical sectors, such as resource stocks (and regions) and financials, provided that earnings dynamics remain supportive.
The high yield and EM corporate credit markets held up well in the recent bond and equity market weakness, suggesting that financial conditions remain supportive and the risk of default remains, as yet, muted by the solid underlying growth. However, credit spreads are now tight and upside limited. Historically credit spreads have tended to be the ‘canary in the coal mine’, tending to start to widen 6 to 36 months before a peak in equities.
What actions have the Multi-Asset team taken in the context of the strategies they run?
The common themes across our more risk seeking strategies are the lifting of equity hedges and an outright increase in equity exposure. Specifically, exposure has been increased in Asia and EM equity markets. Duration has also been lengthened on a tactical basis across these strategies to take advantage of oversold bond markets. More generally across multi asset strategies, within equity sub portfolios the generalised nature of the decline in equity markets has presented opportunities to add individual equities with attractive idiosyncratic characteristics or drivers. Dollar allocations have fallen. In the more defensive strategies, we have chosen to deploy more conditional strategies via call options, to add back exposure while still protecting the downside.
Notwithstanding the tactical opportunities which have now presented themselves, strategically we think that it is important to accept that the current market cycle is increasingly mature and exposures to growth assets should be appropriately balanced.
The views expressed are those of the author at the time of going to print. They do not necessarily reflect the opinion of other investment teams at Investec Asset Management.
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All rights reserved. Issued by Investec Asset Management, issued February 2018.