To date, 2017 has been a benign year, particularly in Europe, where growth has been better than expected with a rejection of more extreme political movements, notably in France and the Netherlands. But we also see greater stability in Asia, particularly in China. Against this we have Trump’s vision of ‘America First’, which seems more like America goes solo. Will his goals prove out of reach if he detaches the US from the rest of the world? The markets don’t think so, but may prove sensitive to any shocks that threaten his intentions.
If you would like to discuss any of this, please do not hesitate to contact me or any of the Acuvest team.
Economic Performance & Outlook
It might be thought odd that two of the western countries where recovery has progressed furthest – the US and the UK – are the ones now most exposed to isolationism and a withdrawal from free trade. This may be because the benefits of the recovery have been so unevenly spread in these countries. While there is some awareness of this issue in the UK, reflected in the policies put forward by the major parties in this month’s general election, there appears to be very little in the US, where the political divide has become so extreme. In terms of the Brexit negotiations, the outcome of the UK election can only weaken Britain’s hand in the negotiations and strengthen the European Union side.
While the US in particular continues enjoyment of its second longest rally ever, there is increasing recognition that a long period of very low interest rates has consequences for bodies which depend on returns on assets for their prosperity. The obvious examples here are banks, life insurance companies and pension funds. The longer that central banks keep interest rates low, the worse this will get. Moreover, we appear to have reached a point where lowering interest rates further has very little effect on economic activity. Might we see a broad G7 attempt to raise interest rates in concert, combined with offsetting fiscal expansion?
Taken overall, the broad picture is that 2017 is likely to see rising short-term interest rates in the US and the beginnings of the same in the EU, including the UK. The real unknown is what effect this will have on inflation; in past economic cycles, we would expect to see wage rises starting to come through, leading to higher inflation. For the moment, markets are taking a fairly sanguine view but we wonder if there will not be hiccoughs in this perspective over the next year or two.
We continue to believe that markets, both bond and equity, will have difficulty in making significant progress over the next couple of years. Markets are vulnerable at current levels to any kind of shock but may drift further upwards in the absence of any rise in interest rates or inflation.
Bond performance over past year
Source: Merrill Lynch, Irish Governments 10+ yrs, German Governments 10+ yrs, EMU All Non-Sovereigns 10+yrs, US Governments 10+yrs, 06/06/2016 – 06/06/2017, total return, locally priced
2016 saw bond yields fall to all-time lows before rising sharply again. German 10-year bonds went negative for the first time in 2016 but have been hovering around 0.25% for most of 2017. There has been little change in the spread of German yields over peripheral, with the exception of Italy where the banking sector is struggling. The Dutch and French elections caused some temporary changes which have now reversed.
Yields do remain low overall: where bonds are being used for matching and it is possible to take some risk, it seems sensible to either shorten duration or move into alternative investments.
Equity performance over past year
Source: MSCI standard core data, 06/06/2016 – 06/06/2017, local pricing, Europe is all EMU members
Markets generally have approached or exceeded their all-time highs, and are up around 20 per cent over the past year. While valuations look stretched on many measures, the general view is there is more to go, based on benign economic conditions and central bank stimulation. The US is counting on fiscal deficit stimulation to target ageing infrastructure and drive growth, although it is by no means certain that this will happen.
Currency movements have advantaged the euro investor over his dollar-based counterpart. In these circumstances, hedging has become far more important and we have been recommending that clients – who have benefitted from being unhedged – should consider changing their stance at this time.
Property values have been reasonably stable (apart from in post-referendum UK). We continue to believe that property exposure is sensible, and are recommending clients who are below target weight in property to move up to target.
We see the Eurozone as the home market for Irish clients, rather than the more concentrated, more volatile, and often less liquid Irish market.
Commodity performance over past year against equities
Source: Thomson Reuters Core Commodity CRB Index, MSCI ACWI equity index, priced in US dollars, total returns, 06/06/2016 – 06/06/2017
Opec’s deal last November to restrict oil supplies in a bid to prop up prices has triggered a rebound in US shale production; Brent crude, the international benchmark for oil, has struggled to reach US$ 50 a barrel in recent months.
We do not foresee any sharp upswings in commodity prices. Opportunities arise from time to time however when particular markets become depressed; in relative value terms, non-energy commodities may offer some short-term protection.
We retain a modest overweight exposure for the diversification benefit and because price levels do not look challenging.
Hedge fund performance over past year against equities
Source: Credit Suisse Broad Hedge Fund Index (priced monthly), MSCI ACWI equity index, priced in US dollars, total returns, 06/06/2016 – 06/06/2017
Hedge funds as a group have posted muted returns over the past year. Although market volatility is significantly lower than that for equities – due in part to lower liquidity – fees remain high and performance has been below par relative to equities for some time now.
Sharp movements in currencies over the past year have given some opportunities for gains (and losses). These funds continue to be a useful diversifier.
Global Tactical Asset Allocation Funds
These funds provide good diversification benefits because of their broader investment universe.
These are floating rate sub-investment grade instruments with a strong covenant and a term of between six and nine years. The premium return over cash rewards illiquidity and credit risks. The class offers another diversification.
Short-term interest rates remain low and sit either negative or barely positive everywhere in the eurozone. The ECB is under no pressure to increase rates, even though economic conditions appear to be improving.
We continue to advise clients to include yield-enhancing alternatives to cash in their portfolios when this can be done at an acceptable risk.
Portfolio Structure & Risk Management
- It is very important that clients have a disciplined management framework for determining how to structure portfolios and how to adjust that dynamically over time.
- Acuvest recommends that portfolios comprise a diversified mix of asset types which balances the desire for high returns with management of the associated risks.
For this purpose, we group assets into three categories: growth (including equities and property), managed risk (including global tactical asset allocation funds, certain types of hedge funds and sub-investment-grade credit risk) and defensive (including bonds and cash).
- Within clients’ portfolios, we currently advocate an overweight position in GTAA funds, high yield bonds, commodities and property. Balancing this, we are underweight equities.
- In a low-return environment, keeping fees low is particularly important.
- In building a portfolio, getting exposure to the equity risk premium efficiently is key. Given its low cost and avoidance of manager risk, passive investing should be considered as a baseline against which to assess the best way to gain exposure. Acuvest does, however, recommend using active managers where we believe they can add value, for example by exploiting their skill or where markets are less efficient.
At current exchange rates, we recommend euro investors to have overseas currency exposure at least partially hedged.