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2018: Where are the investing risks?

1 January 2018

 

Miton’s David Jane takes a view on where some of the key risks might be in 2018, both to the upside and the downside.

When considering the basic economic outlook for 2018, we see the risk mainly to the upside in terms of growth, inflation and interest rates.

Most pundits seem to be stuck in a ‘lower for longer’ post Global Financial Crisis mind-set, but when we look at the hard data it’s difficult to find any substantive evidence of an imminent downturn. That’s not to say the evidence won’t change and there are some data points, such as US long term interest rates, which might suggest we’re getting closer to a downturn but, for now, we see more evidence of continuing expansion than contraction. At the same time, inflation data is tending to surprise to the upside, whether goods prices, commodities or even, finally, wage inflation.

On balance, the risk is that inflation surprises to the upside, along with growth and, ultimately, monetary policy generally tightens to a greater degree than is currently expected by markets.

Fixed income

Hence, our strategy in fixed income, the risk is faster rate rises and therefore, capital losses for longer dated bonds. This is particularly the case in Euro denominated bonds, where yields are so close to zero, no rational investor would participate as there’s no potential for a material positive income or capital gain, but the risk of very significant loss is quite real.

A tiny upward move in Eurozone government bonds or short-term interest rates, given corporate bond yields as low as they are, would lead to capital losses exceeding many years’ income. The inevitability of this event is clear but its timing less so, although the strong global economy makes this event rather more likely next year than before.

In our bonds, we remain in capital preservation and income generation mode rather than return seeking for these reasons, even in markets where pricing is more rational. While we can find pockets of value within sub sectors and industries, we think there is a negative return expectation for the broader bond market.

Equity valuations

Higher interest rates and inflation, if the consequence of strong global growth, might be a positive environment for equities, however there is much talk of high valuations. We think valuations are not a good indicator of returns but a good signal of risk. High valuations mean that negative surprises are highly punished while low valuations mean any upside surprise can lead to high returns. As a result, we need to look for areas where expectations and valuations are relatively low, to give us a higher probability of good returns next year.

We are pragmatic and never like to try to call the turn, but prefer to wait for a new trend to begin to emerge. This year’s market has concentrated on technology driven growth sectors, notably the FANGS, (Facebook, Amazon, Alphabet/Google, Netflix) but also other similar areas such as semi-conductors, medical technology and robotics. We have been beneficiaries of these trends through our thematic approach but given the substantial revaluations these stocks have experienced, the risk here must be greater to the downside than the upside, so we have been reducing.

Upside

Which equity sectors might have greater upside risk? Here we can consider the macro environment and some of our thematic preferences in the context of low valuations. A number of sectors have good upside if inflation re-emerges and also low debt so they don’t suffer from rising rates. A case in point would be some of the infrastructure sectors such as airports, roads and railways. Revenues benefit from economic growth and inflation, while where they have relatively low levels of debt they don’t necessarily suffer from higher rates so we have been adding to these relatively lower risk assets.

Another area which looks to have potential upside is Japanese domestic stocks. While the big international industrial stocks in Japan have been caught up in the AI and robotics whirlwind, many of the domestic sectors have been starting to make progress. These areas trade at relatively low valuations, be it banks, retailers or even railroads, and would benefit hugely if inflation finally re-emerges and domestic growth continues to progress.

Adding risk?

For those with a higher risk tolerance, an area which is beginning to look interesting is traditional auto makers. We have avoided this sector for many years and have been focussed on the new emerging manufacturers, particularly those in China. There have been a number of key worries, such as high levels of leverage, particularly financing of customers vehicles, and the ability of the companies to re-invent themselves in a period of technological change. On the other hand, these companies have some key advantages. One is a major embedded infrastructure from sourcing through to distribution and maintenance. Another is brand loyalty and manufacturing experience. It is not certain who the future winners will be, but the balance of risk has swung in favour of upside in the incumbents, with their existing assets and revenue streams, versus the new entrants with the huge valuations and lack of experience. We have been adding to this area selectively, while reducing the more highly valued Chinese companies.