The shift towards quantitative tightening: implications for 2018
30 April 2018
As the global economy strengthens and the world emerges from the unprecedented era of low interest rates, active managers face difficult choices, says Jonathan Webster Smith, director and head of the Multi-Asset Team at Brooks Macdonald.
Global economic growth has remained on a positive trajectory in early 2018. Inflation has also stayed subdued, despite price pressures building in the US and UK. Nevertheless, equity markets are correcting and volatility has spiked, as rising inflation expectations and the withdrawal of monetary stimulus have pushed US treasury yields higher.
Our aim is to outperform our benchmark as the economic backdrop develops. Corporate earnings growth remains robust and fiscal stimulus measures have boosted sentiment. However, economic indicators suggest the US economic cycle is entering its latter stages; we are wary that the economy may overheat, and of the implications for US monetary policy.
Other major economies continue to expand and subdued inflationary pressures will allow policy to stay accommodative. Political risk remains a concern, particularly given the proliferation of populist politics and trade protectionism.
Our economic clock (below; click on image to expand it) shows that we believe the world’s major economies’ cycles are maturing. During mid-cycle expansions, labour markets strengthen but the economy still has spare capacity. This keeps inflation low and allows monetary policy to remain accommodative, which is ideal for risk assets. As economic expansions mature, labour markets tighten, growth moderates and inflationary pressures build. This forces central banks to reduce policy support, putting pressure on fixed income markets and causing rotation within equities.
Source: Brooks Macdonald
How is this affecting our portfolios?
Despite treasury yields having risen, we still prefer equities to fixed income. Equity earnings growth remains robust, while fixed income markets face multiple headwinds, including removal of liquidity by major central banks, rising US interest rates and increasing government debt issuance. This preference is also supported by the large differential between the earnings yield on global equities (higher) and that of ten-year US treasuries (lower, despite their recent increase).
We have diversified our portfolio through exposure to alternative assets such as structured investments and hedge funds. These are able to provide uncorrelated returns when the correlation between equity and fixed income markets is high.
Nevertheless, sovereign bonds could benefit from safe-haven demand in the event of a market shock, which could be catalysed by a deceleration in growth, increase in inflation, or a global trade war. We continue to monitor developments with a view to changing our asset allocation if appropriate.
Within equities, we retain a preference for Japan, where corporate balance sheets are strong and declines in spare capacity are encouraging investment. The weak yen is supporting the export sector; this should continue as Japanese monetary policy remains accommodative amid subdued inflation. We are also positive on Asia, as China’s robust economy continues to outperform expectations, exceeding the government’s economic growth target.
We have exposure to the lower end of the equity capitalisation spectrum through global smaller companies funds. Smaller companies are often less well researched than their larger peers, which can provide opportunities for active managers. Given recent market performance and rising US interest rates, we have begun to shift some of our ‘growth’ exposure into ‘value’. Generally, growth stocks are longer-duration assets which are valued on their future expected cash flows and are susceptible to increases in the discount rate, while value stocks often act more like bond proxies.
In sector terms, we are positive on various themes such as technology and financials. We make active investments in technology, where many companies are disrupting traditional industries and have potential to experience above-trend secular growth rates. Financials stocks, specifically banks, benefit from rising interest rates, providing a hedge against accelerating inflation.
We are underweight the UK, which faces elevated political risk, despite recent positive developments regarding Brexit. Weak real wage growth is weighing on consumption, the major driver of domestic economic growth.
We continue to apply a balanced approach to portfolio construction, aiming to benefit from the accommodative economic environment, while protecting the portfolio in case the risks we have identified intensify. Given the political and currency risks facing UK investors, we maintain portfolio flexibility so we can make rapid tactical adjustments to asset allocation if necessary.
The value of your investments and the income from them may go down as well as up, and neither is guaranteed. You could get back less than you invested. Past performance is not a reliable indicator of future results.
Brooks Macdonald is a trading name of Brooks Macdonald Group plc used by various companies in the Brooks Macdonald group of companies. Brooks Macdonald Group plc is registered in England No 4402058. Registered office: 72 Welbeck Street, London, W1G 0AY. Brooks Macdonald Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England No 3417519. Registered office: 72 Welbeck Street, London, W1G 0AY.
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