By Michael Stanes, Investment Director at Heartwood Investment Management
Notwithstanding that there has been a recent fading of momentum in the reflation trade, signalled by lower bond yields and the underperformance of certain more cyclical parts of the equity market, we believe the fundamental backdrop remains supportive to financial markets. Markets have come through a quieter period of late, but we view this pause as constructive. Investors’ expectations had moved too quickly and are now being scaled back to more realistic levels. Economic survey data had reached lofty levels which were unlikely to be sustained due to the trailing gap with real activity data. Furthermore, the rolling over of inflation expectations should in time help to relieve the pressure on real incomes and add support to consumption. Overall, global growth continues to present a positive picture. The fundamentals remain supportive to corporate earnings growth, which is already seeing improvement. According to FactSet, companies in the S&P 500 reported their first two quarters of back-to-back profits growth in two years. In addition, plentiful liquidity continues to remain a key driver of financial markets, aided by very accommodative central bank policies.
Although our level of conviction in the economic outlook remains, we have made no changes to portfolios, remaining modestly overweight risk assets. That being said, our risk exposures are tilted towards more specific and targeted areas of the market, whether by sector or market-cap, which reflect our degree of confidence in the fundamental outlook. We are not inclined to increase risk levels further, as we are mindful of upcoming event risk in Europe, especially the French election, as well as broader geopolitical risks. Furthermore, while markets have paused, there has been no major setback and therefore few compelling broad valuation opportunities.
On a final note, we should acknowledge that over the past month the UK government has triggered Article 50, an event that largely went unnoticed by the markets. While Brexit remains a significant event risk in the UK, we believe any fallout will be relatively contained to our domestic market. We reiterate our caution on the UK economy and maintain a defensive home bias positioning.
Equities: Our view remains that a modest overweight in equity is appropriate. The reflation trade has lost some momentum around fears of Trump’s ability to implement his reform plans post the unsuccessful attempt to repeal the Affordable Care Act. We wish to remain fully invested in the US (and no more given valuations), with more targeted exposure – healthcare being one theme we have recently added. We remain positive on Europe, despite the upcoming event risk of the French election, and are encouraged by continuing economic improvements. Japanese equities have delivered lacklustre returns, but we continue to believe that developments in the corporate sector are supportive. We have taken some exposure to small- and mid-cap Japanese equities. Our less preferred market is the UK amid signs of slowing consumption, meaningful structural imbalances and Brexit uncertainty. In emerging markets, we maintain our overweight position but would not add at this point, given recent resilience and possible risk of a trade policy shock out of the US.
Bonds: The loss of momentum in the reflation trade has benefited bond markets through lower inflation expectations, a fall in longer-dated bond yields and support to emerging market debt given a softer tone to the US dollar. A supportive fundamental backdrop has also helped corporate credit markets. Given the hawkish tone of the Fed minutes as well as more focus on an ECB exit strategy, we continue to believe that being short duration remains appropriate. Moreover, headline inflation trends in the UK continue to rise. We hold select exposures to shorter-dated investment grade corporate bonds, specialist lenders and emerging market sovereign debt.
Property: UK property developers and listed vehicles have been solid performers this year, supported by better than expected fourth quarter results and the rally in UK gilt yields. Nonetheless, there are few catalysts that we can see in the shorter term, given supply concerns and uncertainty around Brexit, and we retain our underweight position. On a regional basis, we are primarily invested in cities outside of London, which are less exposed to ‘Brexit’ fallout. Outside of the UK, we are also looking at opportunities in the US REIT (real estate investment trust) market, although we remain wary of the impact of the Fed’s more hawkish stance.
Commodities: The lack of volatility in the oil market came to an abrupt end in the last few weeks, but having fallen sharply prices are now recovering. We continue to expect that an improving global economic environment and a tighter supply/demand balance will ultimately be supportive to commodity prices this year. Direct access to this market is through owning futures contracts rather than the physical assets and while the risk/return profiles are looking more attractive across some parts of the complex, they are not yet at levels where we are ready to invest. We have, though, a position gold in some strategies for diversification.
Hedge funds: While we have held a limited allocation to hedge funds in recent years on concerns around performance, we believe that increasing interest rate divergence should create more opportunities going forward. Our preference remains for macro/CTA strategies, but we are also taking a more positive view on equity hedge strategies, given the greater likelihood of increased stock dispersion (i.e. between winners and losers), as well as credit long/short strategies.
Cash: We have reasonable levels of liquidity across our portfolios both in cash and short-dated bonds, which we will invest as and when we see specific opportunities. Market volatility remains low, a situation unlikely to persist throughout 2017.