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In general, our managers are still constructive on the overall growth picture but are conscious that growth is slowing from what has been an exceptionally high level. None of our managers are forecasting a recession scenario and some feel that the growth slowdown seen in Q1 was more due to transitory factors. The US is seen as very much leading the rest of the World as it is arguably further through the recovery/market cycle compared to other Developed Markets as it moves along the path to normalisation.
Politics continue to dominate with the potential for a trade war between China and the US contributing to volatility. Overall, our managers feel that this is unlikely to escalate with Trump purposely causing uncertainty ahead of negotiations with China, in a bid to put the US in a better bargaining position. It is in the interests of both parties to come to an agreement rather than penalise each other with tariffs.
Looking at styles and changes taking place around interest rates and bond yields, many of our managers feel that we have reached an inflexion point, with the more growth biased stocks that performed very strongly in 2017 potentially looking more vulnerable compared to the more value orientated stocks. The second derivative rationale for switching growth into value is to what extent managers will look at out of favour so called defensives which are on lower valuations.
The Technology sector has been very much in the news with stocks such as Facebook struggling as regulation and data privacy laws are questioned. Looking at the stocks held, there has been a wide variety of returns, both positive and negative. Overall, our managers feel that there could be some short-term volatility for these companies but on a longer-term view technology and automation will be a key driver for companies moving forward.
The behaviour of inflation will be key on the path to “normalisation”. Inflation has the potential to increase mildly with the effects of the Trump tax cuts at this point in the cycle being the main driver. None of our managers feels that inflation will spiral out of control and, overall, the three factors of globalisation, demographics and technological innovation over the longer-term should not dampen inflation levels.
Central bank policy in the US continues to dominate investor thinking. US interest rates are at levels geared for 10% unemployment, not the low levels of 4% we are currently seeing. Markets are pricing in more rate rises in the US, certainly compared to earlier in the year, with our managers now believing it will be very difficult for the Federal Reserve not to carry on its hiking path particularly in respect of the additional fiscal stimulus being applied.
US company earnings for the first quarter of 2018 are forecast to come in at a 17 year high with the one-off factor of tax reform in the US the main contributor. Our managers feel that these levels are incredibly high and therefore unsustainable but, in general, are pleased at good top line (revenue) growth and they do not see a negative overall growth scenario. Focus is more on looking forward at the guidance coming from companies, rather than looking backwards.
Within markets, the first quarter of this year has seen around $1.7trn worth of both actual and potential mergers and acquisitions deals. Some commentators believe that this is a sign that we are close to the top of the market. However, our managers feel that it is more of a sign of businesses being more confident and are pleased that these deals are mostly done in cash rather than with shares. Views differ on how this plays out moving forward with some managers feeling that higher interest rates and therefore higher costs will stifle corporate activity, whilst others feel that consolidation will continue, particularly within the tech, consumer and pharma sectors.
Within bond markets, most of our managers are avoiding longer dated paper, believing investors are not being paid enough for taking extra risk, with one of our managers going further and taking a short position in German 30yr bunds. Overall, duration continues to be generally short, thus less sensitive to interest rate rises. Equities are preferred to bonds with supply issues within bond markets as Quantitative Easing is slowly withdrawn seen as a negative.
Within Europe, survey indicator data have been weak with the Citigroup Economic Surprise Index for Europe reverting from being generally positive to a 6-year low. Our managers are less worried about this, believing that data was so strong at the end of last year that some sort of pullback was inevitable. The rest of the World has fared better with business confidence in the US strong.
Finally, diversification continues to be paramount with our managers continuing to look outside the traditional areas of equities and bonds. Funds and strategies that are uncorrelated or lowly correlated to bond and equity markets are seen as a way to help bolster returns and mitigate downside risk in volatile markets.
As we look back over the year so far, investors have experienced something not seen for many years, increased volatility, with markets pulling back on concerns around the removal of stimulus and geopolitical concerns around trade between the US and China.
Looking forward, central bank policy is still very much in focus. Investors have adjusted their expectations around interest rate rises in the US, which is constructive in terms of lowering the probability of a tantrum associated with bond yields normalising to higher levels and catching up with any inflation threat. Rapidly rising inflationary pressure would force central bankers to raise rates sharply but the consensus view, which we reflect through our TPP related activity, is that this is a less likely outcome than inflation in the US picking up through the business cycle. In the short term the introduction of tax cuts at this stage of the economic cycle may be inflationary and may require higher interest rates. However, over the longer term, demographics, globalisation and technological innovation will serve to dampen inflation.
The potential for a trade war between the US and China is unnerving but the overall conclusion derived from our managers is that this is unlikely to escalate with both the US and China having a significant amount to lose should this happen. There is a huge amount of media noise surrounding this, which we at True Potential, must look through.
At an asset class level, our choices show a preference for fund’s where equities are overweight relative to each funds’ strategic asset allocation. Conversely this reflects a preference for being lower duration across the fixed income spectrum. We note from our managers that company earnings, due to come in at record levels and boosted by fiscal stimulus, are now on much more attractive valuations. Momentum in markets is not so strong and this is leading to an inflexion point, with a change in leadership likely in both asset class and style performance. Growth as a style has performed well but there is evidence that this is slowing. As we move through the market our value managers are seeking opportunities in equities that have been out of favour and one such area is traditional defensives such as utilities and more arguably telecoms. Whether this is the start of new leadership remains up for debate but some of our managers are putting more emphasis on the opportunity. This is partly related, we think, to the shift in expectations for growth which is still positive but moderating.
In conclusion, risks are clearly out there and diversification is therefore key as we navigate through differing market conditions. Our managers have the ability to invest in different countries, currencies and asset classes, all a way to help mitigate risk for your investments. The True Potential Portfolios take this a step further, investing in differing fund manager styles, something unique in the market place and a way to help further guide investors through a changing market environment.