As volatility has returned to financial markets, driven by less accommodative central bank policy and fears over the path of inflation, an overarching question is when is the current cycle likely to end? It has already been the second longest economic cycle in history – from March 2009 to today – and having witness a QE-driven bull market for nearly a decade now, many commentators are predicting its imminent end.
However, the ‘lower-for-longer’ nature of this cycle has differentiated it from previous recovery periods. Yes, we have seen GDP growth and economic indicators consistently improve, but it has been a much more gradual process than in previous recoveries. Therefore, although we acknowledge that we are most certainly late in the cycle, we believe the synchronised global economic recovery that we are witnessing – despite the recent sell-off in financial markets – indicates that there is still plenty of room left for the global economy to grow.
The UK is currently lagging the US and Europe from an economic perspective, but has remained remarkably resilient despite Brexit-related uncertainty. GDP growth is forecast to be 1.5% for 2018, although unemployment has continued to fall and consumer confidence has recovered somewhat, suggesting the risks to growth are to the upside. In particular, we believe the tailwind of global economic growth could provide a meaningful tailwind to the UK economy.
Recent sterling strength has also contributed to inflation easing off, although it still remains sticky at near 3%. The market has priced in a near-certain 25 bps rate rise from the Bank of England (BoE) in May, which would take the base rate to 0.75%. This should contribute to UK gilt year yields modestly rising into year-end. As a result, we have maintained our preference for sterling corporate credit over UK gilts, with attractive spreads in sectors such as insurance and collateralised bonds offering protection against rate rises. Our funds also have a short duration bias, both in sterling and globally, given the strong global growth backdrop and tighter policy environment. As a result of this, we have also increased our weighting to floating rate notes (FRNs), which should offer further protection.
Globally, economic indicators in the US and Europe remain fundamentally strong, having stabilised following a period of rapid acceleration. Given this stronger economic backdrop, global bonds look less attractive, as we expect yields on US treasuries and German bunds to increase more sharply than UK gilts. However, we believe that by overweighting sectors that are offering greater value – such as financials – and maintaining an appropriate currency diversification, we can still deliver attractive levels of total return.
Despite the synchronised global economic recovery continuing to support the equity market upswing through much of January, this relationship then faltered. Fears over less accommodative central bank monetary policy, expensive valuations and higher-than-expected inflation in the US combined to cause global equity markets to correct c. 8%. Although they have recovered somewhat, year-to-date returns remain negative.
Our view is that the global economic backdrop remains fundamentally supportive and that the sell-off was more of a valuation and interest rate construct. Therefore, although a greater correction is likely when the cycle does finally end, it is unlikely to be this year. For example, Citigroup publish a ‘bear market indicator’ constructed of a number of market and economic signals. Of the 17 warning signs, only three are flashing red, compared to 17 in the 2000 sell-off and 13 in the 2008 financial crisis.
However, valuations are undoubtedly stretched in parts of the market that have been subject to investor exuberance, such as US technology. Our funds remain underweight in these areas, preferring to focus on more value plays where we feel sentiment is too negative. These include domestically-focused UK stocks, particularly those we believe are potential M&A opportunities.
Despite negative newsflow around a number of administrations and company voluntary arrangements (CVAs) in the UK retail sector, commercial property has held up well in 2018 so far, outperforming both bonds and equities. Although retail is undeniably struggling, companies that offer their customers an experience or convenience are still well-placed, as UK consumers are simply being much more selective with their disposable income. More broadly, Tesco’s recent bounce back also highlights that companies that are able and willing to adapt can continue to succeed, even if they have to endure some short-term pain.
In contrast to retail, industrials remains the best-performing property sector. Strong demand from e-commerce and online businesses is contributing to rising rents, particularly as supply is currently very scarce. This is very much demonstrative of how the retail landscape has shifted in recent years, as the high street underperforms, the industrial units that form the backbone of the rise in online shopping are benefitting. The office sector is also offering attractive opportunities, centred on regional towns and cities. We expect rents in London to be flat, but growth across the rest of the South East and key strategic cities such as Birmingham and Manchester. In total, we expect property to deliver an annual total return of c. 5.0%, driven by income generation.
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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