Economic performance and outlook
2017 has heralded an economic change from the low growth of the past decade. For the first time since the mid-noughties we appear to be in a situation where most developed economies are growing at a reasonable pace. This looks like a conventional emergence from recession, no longer dependent on easy money and lots of central bank stimulation.
The paradox is that, just as this benign growth situation is appearing, democracies are losing faith in the traditional market economy and appear hell bent on electing leaders focused on protectionism and trade barriers which resonates with the populist response to the 1929 crash.
If we were to ignore the political situation, we would position ourselves in the mid-point of the growth part of an economic cycle, with the expectation of some tightening in monetary and fiscal policy over the next couple of years. The US is somewhat further up the curve, followed by some, but not all, EU members. With a ‘normal’ US administration, we would expect to see both rising interest rates and fiscal tightening through 2017 and 2018. This may indeed transpire, despite the rhetoric of President Trump and his close advisers. It is beginning to look as if the Republican party is determining economic policy and that the populist instincts of Trump himself for economic wars with countries like China and Mexico are going to lead to very little. Rather like the Bush administration, the ‘real’ President may turn out to be the Vice President.
From a political point of view, the biggest current concern is what is happening in France, where the Le Pen campaign looks so much better organised than those of Fillon and Macron. This has already been reflected in the rush to German bonds, particularly from those of France. Our view to date has been that the chances of Le Pen being elected were underestimated – we still believe that this is the case. Moreover, the power of the French presidency is much less constrained than the US, leading to a real possibility that France could leave the eurozone.
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: from past economic cycles, we would anticipate wage rises driving higher prices. 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.
All in all, we continue to believe that markets, both bond and equity, will have difficulty in making progress over the next couple of years and that there will be better buying opportunities than today.
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, 09/03/2016 – 09/03/2017, 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 are now back above 0.3%. US yields are again over 2.5%. There has been little change in the spread of German yields over peripheral, with the exception of Italy where the banking sector is struggling.
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, 09/03/2016 – 09/03/2017, 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. Valuations look stretched and we currently recommend clients maintain an underweight position.
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), with relatively high yields offsetting reduced economic confidence. 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, 09/03/2016 – 09/03/2017
Commodities are dominated by energy with the oil market having been extraordinarily volatile over the past couple of years. Oil producers seem to have gotten their act together recently, with energy prices doubling since their lows of early last year.
We do not believe that we are in a major upcycle 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, 09/03/2016 – 09/03/2017
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 prospects look improved.
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 and 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 and certain types of hedge funds) 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.