Global growth momentum is starting to stabilise, as shown by the moderation in global manufacturing surveys. This trend is to be expected following elevated readings in recent months. Global economic fundamentals are intact and we are encouraged by rising capital expenditure levels, gradual reflation, and the likely positive impact of US fiscal stimulus, all of which should lead to further improvements in corporate profitability.
While global consumption has seen some slowing at the start of the year, we expect that ongoing labour market improvements will lead to moderate wage gains, providing an important underpinning to domestic demand.
The solidity of global growth and supportive liquidity conditions continue to support risk assets, notwithstanding the maturity of the current cycle. The early February wobble, which was triggered by rising bond yields, jolted investors out of their comfort zone following unusually low levels of volatility throughout 2017. We would not be surprised to see more of these types of episodes as the year progresses, especially as financial markets adjust to a different stage of the market cycle, characterised by more ‘normal’ conditions of higher interest rates and higher inflation.
Risks have also heightened around global trade and protectionism, although so far the US administration’s actions should have a fairly limited economic impact. We are comfortable with maintaining our portfolios’ current risk levels: a short duration position in bonds, a modest overweight in equities and an underweight allocation to UK commercial property. We continue to actively source diversified return streams from alternative assets, which we expect are better positioned to withstand higher levels of market volatility. With valuations remaining elevated in some parts of the market, we continue to retain a moderate value tilt within portfolios.
We have obviously witnessed a change of dynamic in markets since mid-January. While US tax changes are positive for growth and corporate earnings are seeing upgrades, the reappearance of volatility from decade-lows has unnerved investors. Energy and utilities have been the weak spots unusually, while technology and smaller companies have shown more defensive characteristics. Overall, we maintain our view that a modest overweight allocation to equities remains appropriate, though mindful that the backdrop of strong fundamentals and liquidity is set against the risks of high valuations. We are still not pushing for a shift back to UK equities at the expense of overseas, remaining underweight relative to other regions. We retain overweight positions in European and Japanese equities, with neutral exposure in US equities targeted to specific themes, such as biotech, energy and insurance. We continue to view our US exposure as a future source of funds on valuation grounds. Our emerging market equity exposure remains tilted towards Asia.
Developed sovereign bond yields have seen notable rises, with the most pronounced moves in the US. Higher inflation expectations and growing confidence in the economic outlook among Fed policymakers have contributed to higher yields. Rising interest rates has also led to high yield bonds and emerging sovereign debt incurring small losses on a total return basis year-to-date. Despite the back-up in yields, we continue to believe that developed sovereign bond valuations remain unattractive and maintain our short duration position. We are targeting ‘niche’ return drivers, such as asset-backed securities and infrastructure loans, until value returns to conventional credit.
Listed UK commercial property has had a weak start to the year, with performance weighed down by the large developers. We are comfortable maintaining our underweight position in UK commercial property, favouring a targeted approach towards diversified, long-term income strategies. Our preference remains for those sectors where there are supply/demand imbalances (industrials and UK regions) and that are less exposed to broader macroeconomic events, such as alternative property exposures. While capital appreciation opportunities are diminishing given the maturity of the cycle, we continue to believe that UK commercial property offers attractive yields over UK gilts (notwithstanding the recent rise in bond yields), which continue to be above historic averages in most sectors.
We are maintaining exposure at current levels, having modestly increased allocation at the start of the year. Commodity prices have been circling near two-year highs over recent weeks, with agriculture being an area of strength. OPEC compliance remains high and supply discipline is a key pillar supporting the near-term outlook. A higher oil price would also be welcomed by Saudi Arabia due to fiscal deficit pressures and in advance of the floatation of the state oil giant Saudi Aramco. Over the longer term, US shale production is likely to reawaken supply pressures. Industrial metals are sensitive to rebalancing and deleveraging in China, but environmental controls introduce supply-side constraints which could be supportive to prices. Gold continues to play a protective role in portfolios in the event of any financial or geopolitical crisis.
5. Hedge funds
We made no change to our current allocation, although we expect more opportunities to arise owing to increasing monetary policy divergence and sector and stock dispersion. Our preference remains for macro/CTA strategies for portfolio diversification, as well as equity hedge strategies that have the potential to benefit from increased stock dispersion.
We are maintaining reasonable levels of liquidity across our portfolios both in cash and shortdated bonds, which we believe will leave us well positioned in higher volatility market environments.
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