Whether it’s summer slumber or a generally satisfactory economic situation, nothing much has changed since we last wrote three months ago. 2017 has continued a rosy year, both economically and politically, and 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.
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
Summer 2017 brought little to shock the markets, and the global economy maintains its momentum. We appear to be in a steady state of economic recovery, no longer dependent on easy money and lots of central bank stimulation.
Experience has taught us however that these periods of somnolence rarely last long – events arise which shift our perception of the world. Politically, Korea is sending clear alarm bells. Markets as yet are assuming that the bellicose rhetoric will come to nothing. But the personalities of Presidents Trump and Kim Jong-Un give little cause for comfort and, worryingly, US presidents have more power in foreign than domestic policy.
Economically, the US continues to thrive. This is due in no small part to market-dominating tech titans achieving rapid growth, high margins and very low effective tax rates. Current low inflation can be explained by the economic consumer benefits provided by these companies, together with continuing over-capacity in most traditional industries. If economic growth continues, focus on inflation must eventually sharpen, but this does not appear imminent.
With Trump, nothing is certain, but with a ‘normal’ US administration we would expect to see both rising interest rates and fiscal tightening through 2017 and 2018. And while most of the developed world is at least a year behind the US, exceptions, such as Germany, may heighten pressure on central banks to slow down economies.
Taken overall, the broad picture is that 2017/18 is likely to see rising short-term interest rates in the US and possibly the beginnings of the same in the EU. What is unclear is the time scale for higher interest rates. The problem is that the long term could be several quarters or several years away; in the meantime, the generally benign scenario with lots of easy money around may continue to push real asset values higher.
We 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, 5/09/2016 – 05/09/2017, 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 0.3% 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, 05/09/2016 – 05/09/2017, local pricing, Europe is all EMU members
Markets generally have approached or exceeded their all-time highs, and are up 15 to 20 per cent over the past year, although European markets have fallen over the summer. 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.
We see the eurozone as the home market for Irish clients, rather than the more concentrated, more volatile, and often less liquid Irish market.
Property values have been reasonably stable. 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.
Commodity performance over past year against equities
Source: Thomson Reuters Core Commodity CRB Index, MSCI ACWI equity index, priced in US dollars, total returns, 06/09/2016 – 06/09/2017
Opec has struggled to enforce compliance with its November 2016 deal to restrict oil supplies. Rising output in the US has further detracted from efforts to prop up prices and Brent crude, the international benchmark for oil, has hovered around US$50 a barrel throughout 2017.
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, 06/09/2016 – 06/09/2017
Absolute performance has been disappointing through 2016 and 2017 and fees remain high.
The defensive qualities of hedge funds should be more evident however in a market reverse.
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.
We had changed our position on currency hedging following the depreciation of up to 20 per cent in the euro versus the dollar. While some movement was to be expected, this was excessive and proved to be artificially high. This has now been largely reversed although we are not yet at levels where we recommend taking off the hedge.