With less dovish tones starting to emanate from central banks globally, relatively high valuations across equities and a cooling off in the London property market, it is safe to say that we are not spoilt for choice in terms of attractive opportunities. That said, global economic growth remains ok with China surprising on the upside and the Eurozone maintaining its strong momentum, with strong Purchasing Manager Index (PMI) readings across both manufacturing and services. Inflation also appears to be rolling over in both the UK and US whilst, for the time being, monetary policy remains supportive.
At Canada Life Investments, we regularly review the positioning of our fund range and one of the most important meetings is our quarterly asset mix review. This is where we review and determine our asset class over and underweights and our favoured regions and sub-sectors. Following a somewhat volatile second quarter, how are we positioned for Q3?
Global equities have been on a fairly significant bull run since 2009, which have left many parts of the market – particularly in the United States – trading on above average valuations. The concern is that lacklustre economic growth could put these valuations under pressure and cause a correction, but we are finding some bright spots.
1. Europe remains our most favoured region, as growth continues to tick along nicely. Consumer confidence and retail sales are also on the rise, which has provided a backdrop of positive earnings growth forecast for 2017 and 2018. The market also looks cheap, with the 10-year average price-to-book (P/B) ratio trading at a significant discount to the US. Although Italy looks to be concern, the political situation has stabilised, reducing the risk to European equities in general
2. We also believe fundamentals are improving in China, ahead of the Party Congress in mid-October. Furthermore, the MSCI has announced that Chinese ‘A’ shares will now be admitted to key emerging market indices, which marks an inflection point in attitudes. With the weighting to ‘A’ shares likely to increase significantly over the next 2-3 years, this should provide a further boost to the equity market.
Elsewhere, we are relatively sanguine on the prospects for Japan, which tends to be more geared in to the global economic cycle. Although recent indicators have been positive, there has been no sign of wage inflation and Abenomics is struggling to make much of an impact. Nevertheless, it remains one of the cheapest markets and profitability is gradually improving, so some selective opportunities remain. In the UK, although the Brexit-related economic panic we witnessed during the second half of 2016 has subsided, politics still remain the concern. The uncertainty surrounding the longevity of the current government and its plans for leaving the EU has left investors nervous, so we expect some volatile trading ahead. Pleasingly, the equity market has remained resilient, and a high dividend yield is proving adequate compensation for long-term investors.
The US remains our least attractive market, primarily on a price basis. We are not forecasting a dire economic outlook for the US as, despite some concerns over the housing sector and auto sales, the economy itself appears to be relatively strong. PMI’s have recovered and employment continues to improve. However, the S&P 500 Index is at record highs and the market is 28% more expensive than its 10-year average from a P/B perspective and is 22% higher on a 10 year price-to-earnings (P/E) basis. We do, however, expect value to outperform growth during the second half of 2017 as higher interest rates benefit sectors such as financials, whilst putting pressure on the valuations of more defensive names.
Bonds have been a source of concern for investors in general of late, as fears have risen that the Bank of England (BoE) and European Central Bank (ECB) will follow the US Federal Reserve (Fed) in unwinding their quantitative easing (QE) programmes and embark on a rate-rising cycle. More hawkish comments from Mark Carney and Mario Draghi saw yields rise in the UK and Europe, putting pressure on government bond prices. However, we do not believe the ECB or BoE actually want to raise rates anytime soon, given that this may put economic growth in jeopardy.
It is important to remember that the BoE and ECB are run by committees and, in general, committees are famous for being risk averse. They will fear being blamed for ‘getting it wrong’, particularly in the Eurozone, where it has been such a struggle to generate sustained economic growth. Therefore, although we are not bullish on the outlook for government bonds – we expect yields to rise modestly this year – we expect that swings in central bank sentiment will create trading ranges and opportunities for fixed income investors. In addition, government bonds also remain a critical part of a diversified portfolio.
We are more positive on the prospects for corporate credit. Although credit spreads are not cheap, nor are they overly expensive from an historical perspective. With solid, if unspectacular, economic growth continuing, we see it as a relatively benign operating environment for companies going forward, with defaults still low and demand for new issues healthy. Across our portfolios we are positioned at the shorter end of the yield curve, however, as we expect yields to rise modestly towards year-end.
In the commercial property world, we are seeing broadly positive rental growth across the general market but some secondary locations are starting to struggle. In contrast, the market for prime properties remains well-supported. What has been interesting of late has been the regional and sector divergence we have started to witness. For example, offices in the South East are outperforming those in London, with rents in the City of London forecast to fall slightly in the second half of this year. Overseas investors, particularly from Asia, are maintaining the pricing of prime Central London property, with a number of deals recently announced including the purchase of the “Cheesegrater” by Hong Kong-based CC Land for £1.15bn.
Industrial units are also performing strongly, with significant demand for available units. Although this has seen pricing remain strong, there have been few opportunities for us as property investors, given the pressure this strong pricing has put on available yields. However, there is still a lack of supply of industrial units outside of the main locations which is giving rise to some attractive prospects. At the other end of the spectrum, the retail space – predominantly in secondary locations – is coming under some pressure given the weakness we have seen in consumer spending. At Canada Life Investments, we have very little exposure to secondary retail within our property portfolio.
In conclusion, although we are unlikely to see the same capital appreciation we have witnessed from the property market in recent years, we are still able to source yields of 5% per annum plus. This income stream is a very handy source of yield at a time of potential volatility and we believe there are still opportunities that we can benefit from as active managers, adding value through selective disposals, refurbishment and effective management.
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