Alex Scott, Chief Strategist, Seven Investment Management
In many ways, 2017 was far better than expected. The global economy certainly performed ahead of expectations, showing decisive and synchronised growth for the first time in several years, and this meant that lingering fears about the Eurozone recovery, in particular, ebbed away. Despite this rapidly improving economy, central banks remained very supportive, inching along the path towards more ‘normal’ monetary policy. We saw interest rate hikes in the US and the UK, and a slower pace of bond purchases in the Eurozone, but policy steps overall have clearly erred on the side of caution. Bond yields rose a little in Germany, but fell fractionally both in the UK and the US. The landscape at the start of the year was dominated by political risk the unfolding Brexit tale, the swirl of scandal around The White House and the threat of its newly elected President lashing out against China on trade or striking against North Korea, as well as fears of destabilising election results in France or Germany. Yet these risks have barely impacted markets – some have passed into history, others perhaps merely faded from view.
Almost all asset classes rose, most with stunningly low levels of volatility, equities almost as calm as bonds and making far greater gains – although the US Dollar, Yen and most emerging market currencies fell notably against the Pound, taking the shine off returns from assets traded in those currencies.
Valuations were quite high for many assets at the start of 2017 – bond yields close to historic lows, equity valuation multiples well above historic averages and for some markets (the US in particular) close to historic peaks. This was a factor keeping us somewhat cautious towards equities through the year – seeing high valuations as being at odds with high political risk and an uncertain central bank stance. These tensions haven’t really been resolved. Most equity markets have become more expensive through 2017, as well as experiencing an extraordinary collapse in volatility, to mill-pond levels of calm. The economic environment today may be good and central banks may be running still on very accommodative policy settings, but can we reconcile the highest market valuations in 15 years and the lowest levels of equity volatility in a generation with the world around us? Let’s consider the bigger picture.
The global economy looks in good shape, and could remain so for some time, particularly if corporate confidence translates to an increase in capital investment, improving the economy’s productive capacity and leading to a prolonged growth cycle. But there’s a risk that today’s optimism embeds tomorrow’s disappointment. There are always clouds on the horizon and it should concern us if investors choose to disregard them: slower growth in China; growing evidence of inflationary pressures in the US and Europe; the related potential for more significant central bank action; and the rise in oil prices, which is starting to take back the windfall boost that cheap energy gave to the global economy when oil prices collapsed in 2015-16.
This has been a long cycle; the third longest economic upswing in the US since 1945. Cycles don’t die of old age or calendar effects, but rather from shifting fundamentals or tighter policy, and often as a result of central bank action. Central banks have fanned the embers of the global economy since 2009, but now it’s clear that recovery has taken hold and the policy mix will shift towards ensuring inflation does not become a threat. Evidence of stronger inflation pipeline pressures – from oil, from stronger demand, from supply shortages, from wage increases – could force the Federal Reserve in particular in to a more aggressive stance. In many past cycles, we have seen an increase in market volatility in the latter years of the economic expansion – even in the cycle that ended in the dotcom bubble and extremely strong market gains, we saw periods of intense volatility leading up to the peak. The contrast today, with volatility collapsing to new lows, raises many questions.
Markets aren’t worrying about this. Perhaps that’s the right view, and today’s steady march higher for global equities can continue amid pleasant economic scenarios, benign inflation trends and a calmer political framework. We, however, fear that it could be a naïve hope: even in good growth scenarios, the point will come where interest rate rises trigger a rise in market volatility (if not a more dramatic reappraisal of the growth outlook), and the risk is that a small rise in volatility could reveal that some investors have pushed risk boundaries further than they should have when the world seemed dead calm, and need to unwind positions in a hurry. Our dilemma (as investors) is balancing the risk of a reversal in markets against the imperative to benefit from strong momentum while it lasts. It’s no good being ‘right’ about a market correction if that means positioning a portfolio much too defensively, much too early.
Our portfolio positioning looks to balance those risks. So we are slightly underweight equities overall, but focused on value and on markets that have lagged the momentum rally. We are selectively buying cheap portfolio insurance (through index put options) to provide some cushion in a market correction. And we are more wary on credit than a year ago, as excess yields for lending to riskier borrowers have been squeezed away. We are also favouring uncorrelated alternative strategies over government bonds, since their real yields remain worryingly low.