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Key Themes – February

In general, our managers have shown a real consensus view believing that the recent sell off in markets was a correction rather than a signifier of something more sinister. They do not see a recession scenario for 2018 and certainly do not envisage another financial crisis. Our managers are comforted by the strength of the global economy and strong company earnings figures believing that although we have seen a reaction from markets, the favourable picture of the global economy is unchanged.

Many of our managers have taken the opportunity during the sell off to “buy on the dip” and have added to risk assets. Other managers have opted more for a wait and see approach hoping for more stability within bond markets.

While newspaper headlines concentrate on the level of short term interest rates, markets are more focused on the level of bond yields, which stretch out over many years. This is illustrated by the yield curve. If short term rates rise above long rates the yield curve is inverted and an inverted yield curve signals lower growth in the future. This is not the case today. Central banks are not aggressively tightening policy and long term investors are not demanding higher rates as compensation for the possibility of higher future inflation.

The US wage inflation figure, which came in ahead of economists’ expectations, was seen as a catalyst for the sell off. However, this surprise came from a minority subset of the sampled workforce (supervisory employees), whose wage growth tends to be volatile. Excluding this group gains were more muted and in line with previous trends.

Our managers were surprised not to have seen a rotation out of the more cyclical areas into more defensive areas of the markets. All sectors sold off similarly, something of a comfort for the managers with investors sticking with their positioning rather than switching elsewhere.

US Central Bank policy has been the key discussion point for our manager partners in February. Interest rates have been rising in the US and the US Federal Reserve bank has indicated 3 further rate rises in 2018. The necessity for 4 rate hikes is also being debated. If implemented, US interest rates will rise to between 2.25% and 2.5%. This is not regarded as debilitating for growth and these levels are not excessive by historic standards. The case for higher rates is easier to articulate on grounds of faster economic growth than on the possibility of higher future inflation. Faster economic growth is clearly evident whereas higher core inflation is not yet fully manifest.

Some of the structural factors influencing inflation are globalisation of trade, technology improvements and demographic trends associated with ageing societies. These factors are reckoned to be structural in nature, pushing down on general price levels. However, as economies expand and surplus capacity is increasingly utilised, price pressures build. If this turns into inflation, interest rates will rise, moving monetary policy from accommodating growth to moderating growth. The US Federal Reserve bank’s task is to make policy judgements that chime with economic stability.

US stocks are currently priced on historically high valuations and are making our more value based managers nervous.They see more value in Japan, Europe and the Emerging Markets.

The Emerging Markets particularly are pricing on a discount both to developed markets and their historic valuation levels and looks attractive to many of our managers. They also feel that the macroeconomic conditions are good in this area.

In terms of investment ‘style’, value vs growth continues to be a key topic discussed. Our managers have different approaches and therefore differing views. However, the one point they all agree on is that value is clearly very out of favour compared to growth. When we will start to see value outperform growth is a key question.

Looking at positioning, our managers are generally, ‘short duration’, and less sensitive to interest rate rises, with one manager taking advantage of ultra low credit spreads to reduce duration even further. As yield levels rise, some of our managers are considering adding to duration as absolute yield levels become more attractive, a change in rhetoric from what we have seen over the last few years.

The UK is attracting differing views from our managers. UK equities appear attractive from a valuation stand point, particularly compared to the US. However, volatility in Sterling and Brexit instability are both worrying. With the recent pullback in markets some of our managers have been adding to this area, concentrating more on the FTSE 250 which comprises more domestically focussed and less currency sensitive companies.

Mark Carney’s comments that the UK is likely to raise interest rates in the UK has attracted mixed views from our managers. The consensus is that this is likely to happen and the Bank of England will take advantage of strong global growth to move towards ‘normalisation’. Some of our managers have expressed concern at this believing that the high levels of indebtedness and low levels of saving in the UK mean this is not necessarily best time to do this.

Finally, on currency, some of our managers have looked towards the safer haven currencies of the US Dollar and the Japanese Yen as a way to hedge risk within their funds.

The main conclusion is that the higher level of global economic activity being experienced is not correctly aligned with historically low interest rates designed to combat the lower levels of growth experienced after the credit crisis. As global growth and monetary policy realign towards historic norms financial markets are likely to experience volatility. However, it is important for investors to remember that higher interest rates are in response to the proof of economic expansion rather than the fear of higher inflation.