Despite heightened geopolitical risk, questionable political decision-making and monetary policy uncertainty, markets have been remarkably stable so far in 2017. At Canada Life Investments, our quarterly asset mix meetings – which bring together all of our investment professionals – provide us with the opportunity to set out our expectations for asset prices for the quarter ahead. As the UK and Europe start to consider joining the US in introducing some form of monetary tightening, what is the outlook for the final months of the year?
The major underlying positive is that the global economy is continuing its synchronised economic recovery, with 3.6% Gross Domestic Product (GDP) growth expected for 2017 and 3.7% in 2018. The US and China continue to tick over nicely, whilst the return of 2%+ growth in the Eurozone has delivered a big boost. The strength of the underlying global economy means that – after a decade of ultra-loose monetary policy – interest rate rises are now expected in the not too distant future. We have already seen hikes from the US Federal Reserve and the Bank of Canada, and the market now expects the Bank of England to raise rates by 0.25% at its November meeting.
These higher interest rate expectations have put pressure on government bonds, with both UK gilts and US treasuries posting negative returns in the third quarter. Corporate bonds did a little better but returns were still muted. We continue, however, to be more optimistic on the outlook for corporate credit. Alongside the positive economic outlook, issuance remains healthy and default rates are low. Although interest rates are set to rise, we expect the steps will be gradual, whilst rates will still be relatively low by historic standards. For example, the Bank of England and the European Central Bank will not want to raise rates too quickly and therefore hamper growth.
From a global perspective, we continue to favour Eurozone corporates, which is driven by the improving economic outlook. Peripheral nations such as Spain, Ireland, Portugal and Italy are all now contributing to growth, meaning the recovery is now significantly more broad-based. This should cause the euro to strengthen versus sterling, particularly given the uncertainty surrounding Brexit.
The commercial property market also continues to tick along and, despite Brexit-related uncertainty slightly dampening demand, capital values have remained steady from a national perspective. The City of London has seen office rents falling marginally in recent months, reflecting Brexit uncertainty around the demand for space from financial companies but other parts of Central London have enjoyed more support due to a more diverse occupier base. The rest of the UK has been more stable due to limited supply and rents and capital values have held up well.
Looking at sectors, prime retail remains well-supported, but secondary locations are starting to suffer due to the continued expansion of online retail. This accounted for 16% of all purchases in 2017 so far and it is forecast to grow to 20% over the next two years. Therefore, retail businesses have been reducing their store footprint, and focusing their physical operations in the more affluent areas. The one outlier in the commercial property market remains industrials, which has continued to outperform. This has not solely down to marquee deals from companies, such as Amazon, for large distribution centres either. The sector’s resilience has proved popular with investors, across all lot sizes. However, yields have been driven to much lower levels and it is now becoming increasingly hard to find value in the area.
In the investment market, London property remains a ‘trophy asset’ for many overseas buyers and we continue to see transactions from China, Germany, the Middle East and the US. For example, despite the Chinese government introducing capital controls on buying property overseas, Chinese companies are still purchasing key assets. This was highlighted by Wanda – China’s largest commercial property conglomerate – pulling out of a £470m deal to purchase Nine Elms Square. However, the transaction continued after two Hong Kong-listed developers stepped in. Importantly, property’s attractiveness for all buyers is still its spread above bonds, which we expect to further support the market for both domestic and overseas buyers. Our focus remains on identifying undervalued assets on attractive yields, such as smaller industrial units in key strategic cities such as Manchester and Bristol.
In the UK, although the outlook for the domestic economy is still a little up in the air, 80% of the equity market’s revenues in fact come from overseas. Therefore, the positive outlook for the global economy largely translates to a positive one for many UK companies. The Brexit risk remains, in that this will lower growth forecasts relative to the rest of the world. However, we still expect growth in the UK, with GDP rising by 1.75% next year. This should support equity prices, with further sterling weakness also benefiting the large and mega-cap names.
Outside of the UK, Europe remains our most favoured equity market driven by improving economic momentum and attractive valuations relative to the rest of the world. European equities have underperformed global equities by a considerable margin over the last decade, which we believe offers significant catch-up potential. Japan also looks attractive, with earnings-per-share (EPS) at record highs and economic confidence on the rise.
The outlook for the US is more complicated, however, with the Shiller price-to-earnings (P/E) ratio currently standing at 31x. Although we expect a robust economic outlook, an upswing in cyclical growth tends to see markets such as Europe and Japan outperform. Therefore, despite consensus EPS growth of 15% forecast for next year in the US – which should counter some stretched valuations – we are finding better value in other markets.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
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