Schroders Live: Positioning for change

Scope for equity rotation favouring value stocks

While US equities have benefited from a strong upward trend and the “reassuringly expensive” tag over recent years, 2016 saw the balance tilt in favour of value¹ stocks and markets that are more sensitive to the economic cycle, according to Johanna Kyrklund, Global Head of Multi-Asset Investments.

“Leadership now is in the more cyclical parts of the world such as Japan and we have also turned more positive on Europe,” Kyrklund said. “The Japanese economy is showing signs of improvement.” She points to Japan’s weakening currency as a key advantage in a low global growth environment.

She sees the resurgence of value stocks as the most promising trend for 2017, particularly with the more recent added tailwind of inflation picking up.

Kyrklund still sees support for US stocks, which is necessary for positive sentiment globally for equities, with 10-year Treasury yields below 3%. A move above the 3% level, while a painful transition, would reflect a welcome normalisation of the cycle.

This doesn’t appear to be imminent though. Azad Zangana, Senior European Economist and Strategist, thinks moderately weaker economic conditions in the first half of the year will keep the Federal Reserve on hold, before a pick-up allows for two hikes later on, and he sees the European Central Bank on hold for at least another year.

Trump impact

With President-elect Donald Trump due to be officially sworn-in on 20 January, speculation, not to mention uncertainty, abounds as to what policies he will or will not enact.

“The only thing that is clear with Trump is he can’t deliver on all his promises,” said Zangana. “The tax cuts he has talked about altogether amount to 5-7% of GDP, not including infrastructure spending. Somebody is going to be disappointed, we just don’t know who.”

He also questions Trump’s claims on job creation in view of the ageing population in the US and already very tight labour market.

For Kyrklund: “The market had got ahead of itself on Trump policies.” Although she adds that the post-election rally also reflected positive economic conditions.

Brexit uncertainty

The initial events following the UK’s referendum decision to leave the EU have confounded the gloomier predictions; however Zangana and Kyrklund think that the impact was cushioned by a weaker pound, which may now be undervalued, while delayed corporate investment decisions will be a medium-term drag.

Zangana points out that the triggering of Article 50 will only give so much clarity, meaning that a transition deal, potentially lasting four to five years, will be needed.

More broadly, and related to Brexit, the rise of anti-establishment, anti-Europe sentiment on the continent is key to watch.

“Establishment parties might win [upcoming] elections, but in the UK UKIP didn’t need to win an election to get what it wanted. Often politics is more about regime shift,” said Kyrklund, who has been short the euro as a hedge against political risk.

“There is a real underlying trend of anti-European sentiment developing which we can’t afford to ignore.”

Improving outlook for emerging markets

“The traffic light for emerging markets equities has turned amber, having been red for a number of years,” Kyrklund said, adding that valuations had reached extreme levels in 2016.

More so than in equities, Kyrklund sees “definite value” in emerging market currencies, citing the attractive carry² on currencies such as the rouble. She also revealed that the Schroders Multi-Asset team has taken some exposure to the global reflation³ trade through resources stocks and direct investment in commodities, but cautioned that the lack of pick-up in global trade argues against becoming too bullish.

Zangana takes a similarly measured view. He notes cyclical upsides, with Brazil and Russia coming out of recession and cutting interest rates.

“Countries which have stabilised their currencies after the commodities collapse can now start cutting rates to support growth. This is a sweet spot for investors.”

^{1. A value stock is a one that is trading at a lower price relative to its fundamentals (e.g., dividends, earnings and sales) and thus considered undervalued by a value investor.↩}

^{2. A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. This strategy is very common in the foreign exchange market.↩}

^{3. Reflation is the introduction of fiscal policy intended to stimulate the economy after periods of stagnation or contraction.↩}