Economics

Outlook 2017: Multi-Manager

Our multi-manager team looks ahead to 2017, when it expects inflation to come to the fore and perceptions of what is a "safe" asset to change.

29 November 2016

Marcus Brookes

Marcus Brookes

Head of Multi-Manager

Robin McDonald

Robin McDonald

Fund Manager

  • Perceptions of what are “safe” assets may reverse in 2017
  • The rally in “value” style equities has legs
  • Recent losses in bonds are likely to build

For the last four years, measures of inflation have consistently surprised on the low side of expectations.

As a result, the primary trend within markets has been to invest in rate-sensitive investments like bonds, which benefit from low inflation, and their equity surrogates which benefit from falling bond yields.

So stable has been this trend, that such assets now carry an almost irrefutable reputation for being “safe”. This is the sort of extrapolative thinking that prevails at the mature phase of every major bull market.

So when is a supposedly “safe” asset exposed as a risky investment? In our view, there’s a good chance the answer is 2017.

Our outlook for the coming year is heavily influenced by the likelihood that inflation now surprises on the high side for at least a few quarters.

This prospect has already instigated a significant rotation within the equity market and a sell-off in fixed income (i.e. bonds). These new trends have accelerated since the election of Donald Trump.

A climax in the bull market for safety?

A focus of client meetings this year has been how (and inevitably when) the contemporary bull market will end.

Before we attempt to answer that question, this cycle has to be understood for what it is – namely an intense bull market in bonds, with some equities benefiting as a consequence.

For context, the cycles that peaked in 2000 and 2007 could be described as pro-growth. That is to say it was enthusiasm about expected future growth that underlined the willingness of investors to speculate in risky securities. When the growth narrative broke, the bull market collapsed.

The contemporary cycle, by way of contrast, can largely be defined by historically low economic growth and low inflation.

This backdrop has been far more beneficial to fixed income than equities.

Although the equity averages have of course moved higher, the returns have been concentrated in securities that have bond-like characteristics and therefore benefit from falling yields (premium dividend payers with low earnings variability and strong balance sheets).

Our outlook for the coming year is heavily influenced by the likelihood that inflation now surprises on the high side for at least a few quarters.

This has not been a bull market for more economically sensitive groups like mining and banks. At least not until very recently…

In our view, this bull market in safety was always likely to climax with a shift in expectations towards better nominal growth. With higher inflation pretty well assured for the first half of 2017, Donald Trump’s election has (rightly or wrongly) now given the market a more pro-growth narrative on top.

For those late to the party, this serves to legitimise the momentum we have recently seen in the cycle’s laggards; hence capital begins to flow into the beneficiaries of higher growth and out of the incumbent leaders – those assets that appeared best-placed only if the world was secularly stagnating.

At the risk of being misinterpreted, what we are talking about here is a window of opportunity between now and the next recession to benefit from a period of mean reversion, as the extreme crowding in bonds, bond proxies and yield plays dissipates and owners of those assets suffer drawdowns.

Outside of an economic slowdown or crisis (for which there are admittedly a few candidates – see below), we think it is too risky to remain overinvested in many assets that currently bear the safety moniker, but have really just ridden the wave of falling bond yields.

This includes commercial real estate, infrastructure funds and alternative financing vehicles. Cumulatively there is massive over-investment in this space. Valuations are historically extreme and the perception of risk is low.

Equities

To summarise our view on equities, we believe the rotation that began in February of this year and accelerated post the US election has legs.

This is most beneficial towards the “value” style, where the majority of our equity assets are currently concentrated.

Fixed income and cash

Quite simply, we believe the short-term losses that investors have suffered in recent months have the potential to build and ultimately become quite substantial.

Higher inflation is not great for zero-yielding cash but is even worse for long duration bonds.

Investors need to be watching these markets closely, particularly if corporate and low-grade bonds join the deterioration in government debt.

Alternatives

We have a number of funds in the portfolios that we believe are set to benefit if the primary trend in fixed income has indeed transitioned from one of falling yields.

So influential has been this trend that one can benefit from its reversal across multiple asset classes.

We are exposed to a combination of absolute return funds as well as gold, which has historically been a useful diversifier during periods of higher inflation.

Caveat emptor

It would be remiss not to briefly cover off some of the risks that contest not only our position towards the market in general but also the views expressed above.

This outlook is being written ahead of December’s Italian referendum, which kicks-off a season of political event risk in Europe.

Both Brexit and Trump’s election were seen as bearish for the market before they came to pass, yet buying what fleeting dip there was has in the short-term been profitable.

We would not expect the heightened risk of a eurozone break-up, were it to occur, to be taken so calmly.

The European election season represents one risk, but it was only 12 months ago that China represented the primary risk for many.

Suffice to say that China remains a source of potential fragility that investors may once again seek to hedge over the coming 12 months. Such a turn would put pressure on commodities for instance.

And finally, we’ll save our last words for President-elect Trump, whose victory has so far triggered a powerful and decisive shift in investor expectations.

He inherits a divided US electorate and an economy in a fragile state. We’ll have to wait and see which policies he believes will “make America great again”.

It’s not impossible, but it is fraught with difficulty. Not least in keeping the bond market under control.

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