After such a long period of economic expansion and strong market returns, it is only natural that investors are on the lookout for signs that this cycle is coming to an end. Whilst there are clearly some signs emerging that we are towards the latter stages of the cycle in some parts of the world, overall we continue to expect this period of healthy synchronised global growth to carry on at least through 2019.
The US economy has benefitted from recent tax reform and deregulation, but it is unusual at this stage of the cycle with growth already healthy to be providing stimulus to an economy and worsening the budget deficit. The short term economic and equity market impacts have been positive, but there is a danger that the impact on US inflation, interest rates, the dollar and debt levels will potentially have more negative effects from 2020.
President Trump has also continued to move US policy in a different direction in a number of other areas, not least in terms of trade policies. There has been an escalation in protectionism and a number of tariffs announced, but to date the actual impacts have been relatively modest. However, there are concerns that ahead of midterm elections in November things could escalate to a level that may undermine confidence.
Europe has also suffered political concerns in Italy, Spain and now even Germany, but despite a loss of momentum in early 2018 the economic outlook appears reasonable. There has also been some disappointing data out of China and some political issues in a number of emerging markets, but economically overall they continue to have positive long term structural drivers and are the main contributors to global growth.
The UK economy has lost momentum since the time of the Brexit vote and early 2018 growth was further undermined by the weather, but conditions (and the weather) have improved. Having held back on anticipated interest rate increases, it is widely expected that the Bank of England will look to raise rates in the second half of 2018. The UK remains in a challenging political environment, especially given the difficulty of landing a form of Brexit that will satisfy politicians, voters and the rest of Europe. However, further signs of progress towards a softer form of Brexit will help reassure investors.
It is easy to focus on the number of ongoing political and geopolitical issues that are attracting investors’ attention, but to date none of these issues appear significant enough to change the robust economic and corporate environment that remains the fundamental medium to longer term driver of markets.
Whilst the risks from these sources will need monitoring, the other key area of risk to watch is the activity of central banks as they look to withdraw the exceptional level of monetary policy support that has aided the post-financial crisis economic recovery and boosted asset prices. The normalisation process is furthest advanced in the US, where interest rates continue to be increased and quantitative easing has turned to quantitative tightening. With other central banks moving more slowly interest rate differentials have widened and with US bond yields up towards 3% and stronger economic growth there has been a strengthening of the dollar. With a synchronised global recovery and some signs of inflation returning, it is anticipated that most central banks will move towards policy normalisation, but these changes are expected to be gradual and well flagged to avoid destabilising asset markets that have been long supported by loose monetary policy.
Inflation and monetary policy changes will be particularly important to bond markets, where investors have enjoyed a very long period of declining yields and rising prices. Yields are up from their lowest levels in the UK but remain very low by historic standards. Structural factors such as demographics, high debt levels and the impact of technology on inflation help justify interest rates and bond yields remaining relatively low, but there is certainly scope for the normalisation of monetary policy to put some pressure on fixed income asset returns.
With the yield on 10 year UK government bonds of only around 1.3%, this is below the level of inflation and provides very little income support to offset any potential capital losses if yields rise. Whilst the return prospects look modest at best, it should be remembered that government bonds do normally provide some protection for a diversified portfolio in times of market stress. Within fixed income assets we retain a modest preference for corporate bonds and the additional income they provide, but are mindful that yield spreads are relatively tight and would be vulnerable were the economic cycle to deteriorate.
At or above trend growth in most major economies has translated into robust corporate earnings, especially in the US. The long period of strong equity gains left most valuation measures at above average levels in early 2018, but the combination of relatively flat market returns and strong corporate profits have improved equity valuation attractions. Whilst the pace of global corporate earnings will likely ease they are expected to remain in good overall shape and alongside reasonable income support (especially in the UK where the dividend yield is approaching 4%) this provides justification for still having a preference for equities over cash and bonds albeit not as strong as in recent years.
Within equities we have begun to see relative value in the UK market, which has underperformed global markets in recent years and remains out of favour with global investors. There remain UK specific challenges to overcome, but with a lot of bad news priced in we are looking for opportunities to purchase quality UK companies at relatively attractive prices.
The US market has many attractions, but a lot of good news has been priced into those assets. An international area where we see long term value opportunities are the emerging markets. As evidenced in recent times, these remain the most volatile equity markets but despite a number of political challenges and the impact of the stronger dollar they retain their fundamental attraction of superior long term growth potential.
For those areas that can invest directly in commercial property (such as With-Profits), the market continues to be supported by the relatively good yield that rental income produces. Within property, the retail sector remains under pressure but other areas such as industrial properties are more positive.
The gradual normalisation of monetary policy around the world is currently expected to include a small number of gentle UK interest rate increases in coming years, but rates will remain very low by historic standards and higher inflation has left cash deposits struggling to offer anywhere near real returns for savers.
In summary, the benefits of healthy global economic growth and robust corporate earnings continue to provide a positive fundamental backdrop for markets. However, the stage of the economic and market cycle, the gradual shift in monetary policy conditions and the volume of potential political risks mean that market volatility is unlikely to return to the benign conditions of 2017 and a less aggressive pro-risk investment position may be merited.
The long period of healthy asset returns from all areas has left most asset classes relatively highly valued and it would be wise to expect a period of more modest returns going forward. Fixed income valuations look the most stretched and alongside cash offers limited return prospects, but equities and commercial property still offer decent prospects for returns ahead of inflation and our portfolios remain tilted towards those areas where possible.
As always, investors must be prepared for some periods of volatility by ensuring their overall investment portfolio is well diversified.