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Markets have staged a partial recovery, regaining some of the ground lost in the correction at the beginning of February.
The catalyst for the sell off, the move up in American wage inflation, has, upon reflection, been taken as evidence of a resurgent economy and with the US due to benefit further as the recent tax cuts feed through, the markets have returned to “glass half full” mode.
The global economy is continuing to enjoy synchronised growth, albeit with countries at differing stages. The US is in late cycle, coming to terms with monetary tightening but enjoying strong corporate earnings growth. Japan, at the other extreme, looks set to retain its programme of quantitative easing for the foreseeable future but is also reaping the benefits of economic reform. The UK and Europe lie geographically and economically somewhere between the two.
The US remains popular. Valuations appear full but are being supported by corporate earnings which are continuing to grow. The twin trade and budget deficits are a cause for concern as is the potential for tariffs to escalate into a fully-fledged trade war. However, a weakening dollar will help boost trade and most of our managers remain positive.
In Europe valuations are cheaper. The outlook for corporate earnings is more subdued than in the US and uncertainties surrounding Brexit and the aftermath of the Italian election are affecting sentiment. However, the bloc is behind the US in terms of its recovery and so provides an opportunity to extend the business cycle. In addition, the fundamental attractions of Europe represent a defensive play should we experience further market turbulence.
Japan too represents a means of tapping into growth in the global economy and should hold up well, buoyed by attractive valuations, economic reforms, quantitative easing and inflows of foreign capital.
Emerging Markets are likely to exhibit volatility in the face of rising US interest rates but enjoy modest valuations compared to their developed market counterparts. India is increasingly in focus as China matures as an economy and begins to slow.
By contrast the UK has long been out of favour with investors. Despite attractive valuations uncertainty over the course of Brexit negotiations and what the effect of life outside the single market will be have meant investors have remained on the side lines. However, the UK is now emerging as a non- consensus trade with some managers increasing their exposure, viewing it as a defensive market denominated in an undervalued currency.
While trade wars and geo-politics remain a concern, the key focus centres on inflation. US consumer confidence is strong, unemployment low and Trump’s tax reforms will add further stimulus to an economy already firing on all cylinders. In response to the expectation of stronger growth, the outlook for interest rates has changed markedly since the early part of the year with markets now expecting three to four rate hikes in the US this year and a further two rises in 2019.
Changing interest rate expectations can be accommodated by markets but not without some upheaval. A lot hinges on the speed and extent of the required adjustments. Fixed interest markets will remain a difficult place in which to make money but short dated bonds have a role to play in mitigating investment risk.
As interest rates, which are still at emergency levels, and global growth, which is accelerating, realign to some sort of equilibrium, volatility is likely to be a natural consequence. The need for adequate diversification has grown in importance.
However, while the major economies are experiencing synchronised growth, they are not experiencing synchronised monetary tightening and opportunities remain. Corporate earnings are pulling through and provide a useful counterbalance to the valuation worry and the upward shift in bond yields that is taking place.