Mid-year markets: what's changed since January?
Reflecting back to look forward
The middle of the year always provides an opportunity to review our investment strategy relative to the beginning of the year and identify what, if anything, has changed.
We came into 2018 positioned for reflation (a recovery in the low rate of inflation). This is a strategy we established in 2016, with an emphasis on emerging markets and cyclical (ie economically sensitive) positions. But we took this down a gear in the first quarter after we became concerned about equity valuations.
This meant reducing our equity exposure and diversifying into government bonds and commodities, as well as adding to defensive currency positions in the US dollar and the Japanese yen.
Stockmarket valuations have improved for the first time since 2015. Since the start of the year, the price-to-earnings ratio on the main US stockmarket index, the S&P500, has contracted from 22.4 to 20.7.
(The PE ratio is a valuation measure which shows the relationship between a stock price and its company’s earnings. A low number represents better value.)
In emerging markets meanwhile, we’ve seen bond yields rise (which means prices have fallen) and emerging market currencies have weakened by 7% on average. This suggests that there are now some fresh opportunities to potentially generate return in this region.
At the beginning of the year, we also stated reasons why "3% was the magic number". As long as global GDP growth stayed above 3% and the US 10-year Treasury yield stayed around 3%, the reflationary environment would continue and equity markets would be supported. So far these conditions have been met.
Crucially, we are still not overly concerned about inflation. Yes, we should expect an increase because of the late stage of the economic cycle we are in – but we believe that technological disruption and aging demographics are suppressing inflation. Also, the Federal Reserve is very much on the case in terms of keeping inflation in check.
This should ultimately preclude the need for overly aggressive monetary tightening (ie the central bank raising rates dramatically to curb inflation).
On some fronts, however, the news has deteriorated:
- US trade protectionism: President Trump has stepped up his protectionist rhetoric and, as outlined in our previous outlook, this poses a potential challenge to our growth forecast. At the very least, the uncertainty created by his comments is likely to weigh on global trade this side of the November mid-term elections.
- Strengthening USD: The US dollar has strengthened, driven by the divergence between the Federal Reserve, which is still intent on raising rates, and the European Central Bank (ECB), which expects to keep rates on hold for another year. China also recently announced an easing of monetary policy by cutting the country’s banks' reserve requirement ratio (ie the amount of cash banks must hold in reserve), which has weakened the renminbi. We don't expect further US dollar strength from these levels.
- European political risk: There has been a resurgence in political risk in Europe. The Italian government states that it supports the euro, but does not appear to want to play by the fiscal rules of the eurozone. Meanwhile, the ECB has signalled its plan to start unwinding its quantitative easing (ie bond buying) programme later this year, which could pose challenges to corporate and sovereign bonds in the eurozone as it removes a major support for them.
For now we are patiently waiting for better opportunities, focusing on maintaining a diversified stance. Broadly speaking, we are looking to keep our powder dry for the autumn, when there could be greater clarity on political risk or more attractive valuations.
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