Economic Outlook – August 2017
Following a review of our portfolios for 2017/18 we have made a number of changes to the underlying asset allocation of our portfolios since 2016/17. Much of this is due to our views on where global markets stand now and also the areas where we feel growth can be achieved over the coming months. All the time we focus on maintaining diversified portfolios to keep the volatility within our agreed parameters.
This document is in addition to our Investment Manual 2017/18 and represents our views at the current time. We continue to monitor the performance of various sectors and should we feel the need to change our asset allocation, we are able to recommend this to you.
UK Markets
Broadly, we have reduced the allocation to UK equity holdings across our portfolios. Although our domestic market has continued to defy commentators who predicted a post Brexit downturn and results have beaten many expectations since the Referendum (mainly due to Sterling depreciation), we believe the UK markets are still at risk of political uncertainty. We are also not “out of the woods” with regard to our exit of the EU.
Some economists are suggesting that in order to keep inflation subdued, the additional Quantitative Easing (QE) introduced in August 2016 may need to be cooled off; otherwise the accelerated money growth in the economy, rising consumer credit, low unemployment rates and above target inflation may lead to the argument for an interest rate increase later in the year. Our view, which is shared by many on the Monetary Policy Committee (MPC), is that currency can change rapidly so interest rates will probably stay where they are until sterling weakness becomes the new norm or sterling strengthens again. *
*The extract from the recent MPC minutes in June 2017 at the end of this bulletin are instructive
Global Markets
Overall, World economic growth continues at a slower pace but we do expect to see signs of improvement within certain countries such as the US and China who are actively promoting Fiscal policies to stimulate growth. That said, we believe it prudent to only have modest growth expectations over the next few years. We believe the two biggest risks to Global Markets will continue to be political risk (despite a number of elections having recently taken place) and the valuation risk.
Financial assets, especially the bond market, are expensively priced but while inflation remains under control the global bond yields should not come under too much pressure for the time being.
US
We have decided to allocate a higher proportion to US holdings than any other region. Data confirms that US equities have rallied on the back of improved global economic conditions and the potential implementation of fiscal easing and deregulation. It is important to note, however, that expectations for an upswing of growth remain modest for the next few years as the hard indicators such as profits and revenue growth, manufacturing output or real GDP growth have been somewhat lacklustre.
Far East
The decision was made to reduce the exposure to Asia Pacific (excluding Japan) across the board within our portfolios, but, reintroducing exposure to Japanese holdings by the inclusion of Japan as a geographical allocation in its own right.
China’s exports have continued to be lacklustre since February 2015 and only small improvements in imports have started to show in recent data. Domestic credit growth has slowed abruptly year on year and China’s Central Bank have started to raise interest rates (closely following the US Federal Bank) to prevent Chinese Currency depreciation and hoping to dampen a surge in house prices. Due to these reasons, some economists do not believe an upswing is feasible in the shorter time frame.
The Japanese economy has now grown for four consecutive quarters; this is the longest run of growth in three years. This is primarily the result of increased exports (the depreciation of the Yen against the US Dollar having a positive impact) but private spending still remains subdued. Although Japan has concerns regarding the withdrawal of the TPP by the US Government, Japan’s exports to the US have improved and future economic discussions were agreed. Due to our belief that the US could lead global growth, we felt that now was an opportune time to include Japan into our portfolios.
Emerging Markets
Since China is by far the largest emerging market, and the biggest buyer of commodities, the lack of growth in the Chinese economy has had an impact on a number of the emerging markets who supply commodities. Therefore, we expect the outlook for these economies to remain stunted. Should the rest of the global markets improve, however, we could see emerging market holdings become more attractive.
Europe
The European Area has been, and will continue to be, dominated by politics due to (in part) the continuing discontent in Italy, the ongoing Brexit discussions and the potential confrontation between the International Monetary Fund and the EU over the existing loan package to Greece. As such the economic outlook is subdued in the short term.
The major economies are currently doing well though and Gross Domestic Product (GDP) has remained steady year on year. Inflation is expected to remain under target and Corporate earnings are improving on the back of investor sentiment becoming more positive.
Fixed Interest Securities
Government Bonds & Gilts
The decision was made to reduce the exposure to short duration UK Gilts as the current yields make it fairly difficult to achieve any return after costs. Instead, the portfolios will allocate more in longer term duration bonds although they are also proving to be fairly expensive after the recent Sterling moves.
We have introduced a new allocation in the portfolios to Overseas Government and Index Linked Bonds. Due to the hints from both the European Central Bank and the Bank of England that there was a consideration to reduce the amount of economic stimulus, the government bond yields rose. The US Federal Reserve has suggested that interest rates are likely to increase later this year which has seen the yields from the US government bonds drop slightly.
We continue to monitor inflation and the interest rate outlook but, other than short term volatility, we still fundamentally believe in Government Debt being an important and irreplaceable element in portfolios.
Corporate Bonds
The compression of credit spread was a significant feature of 2016, with the difference in yield between corporate and government bonds narrowed markedly and remained very low. Investors in Corporate Bonds have therefore been facing lower yields and in turn compensated less for the additional risk taken for investing in Corporate Bonds. This has mainly been due to corporate bond purchase programmes undertaken by the ECB and Bank of England.
However, following the extended period of low growth in this sector, there is some optimism in the global markets along with the expectation of higher inflation. Consequently, Corporate Bond yields are starting to increase slightly although this is not completely the case for UK Corporate Bond performance which is largely limited due to Brexit concerns and a slowdown in domestic growth.
Overall the expectation is for global corporate bond yields to increase in 2017/18 although this will be largely dependent on inflationary reactions to fiscal policies within the various regions.
Property
The UK Real Estate cycle is at a mature stage and expectations of further capital growth are largely expected to be limited although the income production from commercial property still remains attractive. Overseas, European property continues to perform well in a global context – Stronger economic growth and low supply are supporting healthy income growth in this sector. The US market is also showing low vacancy rates across most sectors and due to demand, it is believed for there to be opportunity for rental growth in this sector.
*Extract from the MPC minutes
“At its meeting ending on 14 June 2017, the MPC voted by a majority of 5-3 to maintain Bank Rate at 0.25%. The Committee voted unanimously to maintain the stock of sterling non-financial investment-grade corporate bond purchases, financed by the issuance of central bank reserves, at £10 billion. The Committee also voted unanimously to maintain the stock of UK government bond purchases, financed by the issuance of central bank reserves, at £435 billion.
The MPC set out its most recent assessment of the outlook for inflation and activity in the May Inflation Report. That assessment depended importantly on three main judgements: that the lower level of sterling continues to boost consumer prices broadly as projected, and without adverse consequences for inflation expectations further ahead; that regular pay growth remains modest in the near term but picks up significantly over the forecast period; and that more subdued household spending growth is largely balanced by a pickup in other components of demand.
CPI inflation has been pushed above the 2% target by the impact of last year’s sterling depreciation. It reached 2.9% in May, above the MPC’s expectation. Inflation could rise above 3% by the autumn, and is likely to remain above the target for an extended period as sterling’s depreciation continues to feed through into the prices of consumer goods and services. The 2½% fall in the exchange rate since the May Inflation Report, if sustained, will add to that imported inflationary impetus.”
This document is in addition to our Investment Manual 2017/18 and represents our views at the current time. We continue to monitor the performance of various sectors and should we feel the need to change our asset allocation, we are able to recommend this to you.
UK Markets
Broadly, we have reduced the allocation to UK equity holdings across our portfolios. Although our domestic market has continued to defy commentators who predicted a post Brexit downturn and results have beaten many expectations since the Referendum (mainly due to Sterling depreciation), we believe the UK markets are still at risk of political uncertainty. We are also not “out of the woods” with regard to our exit of the EU.
Some economists are suggesting that in order to keep inflation subdued, the additional Quantitative Easing (QE) introduced in August 2016 may need to be cooled off; otherwise the accelerated money growth in the economy, rising consumer credit, low unemployment rates and above target inflation may lead to the argument for an interest rate increase later in the year. Our view, which is shared by many on the Monetary Policy Committee (MPC), is that currency can change rapidly so interest rates will probably stay where they are until sterling weakness becomes the new norm or sterling strengthens again. *
*The extract from the recent MPC minutes in June 2017 at the end of this bulletin are instructive
Global Markets
Overall, World economic growth continues at a slower pace but we do expect to see signs of improvement within certain countries such as the US and China who are actively promoting Fiscal policies to stimulate growth. That said, we believe it prudent to only have modest growth expectations over the next few years. We believe the two biggest risks to Global Markets will continue to be political risk (despite a number of elections having recently taken place) and the valuation risk.
Financial assets, especially the bond market, are expensively priced but while inflation remains under control the global bond yields should not come under too much pressure for the time being.
US
We have decided to allocate a higher proportion to US holdings than any other region. Data confirms that US equities have rallied on the back of improved global economic conditions and the potential implementation of fiscal easing and deregulation. It is important to note, however, that expectations for an upswing of growth remain modest for the next few years as the hard indicators such as profits and revenue growth, manufacturing output or real GDP growth have been somewhat lacklustre.
Far East
The decision was made to reduce the exposure to Asia Pacific (excluding Japan) across the board within our portfolios, but, reintroducing exposure to Japanese holdings by the inclusion of Japan as a geographical allocation in its own right.
China’s exports have continued to be lacklustre since February 2015 and only small improvements in imports have started to show in recent data. Domestic credit growth has slowed abruptly year on year and China’s Central Bank have started to raise interest rates (closely following the US Federal Bank) to prevent Chinese Currency depreciation and hoping to dampen a surge in house prices. Due to these reasons, some economists do not believe an upswing is feasible in the shorter time frame.
The Japanese economy has now grown for four consecutive quarters; this is the longest run of growth in three years. This is primarily the result of increased exports (the depreciation of the Yen against the US Dollar having a positive impact) but private spending still remains subdued. Although Japan has concerns regarding the withdrawal of the TPP by the US Government, Japan’s exports to the US have improved and future economic discussions were agreed. Due to our belief that the US could lead global growth, we felt that now was an opportune time to include Japan into our portfolios.
Emerging Markets
Since China is by far the largest emerging market, and the biggest buyer of commodities, the lack of growth in the Chinese economy has had an impact on a number of the emerging markets who supply commodities. Therefore, we expect the outlook for these economies to remain stunted. Should the rest of the global markets improve, however, we could see emerging market holdings become more attractive.
Europe
The European Area has been, and will continue to be, dominated by politics due to (in part) the continuing discontent in Italy, the ongoing Brexit discussions and the potential confrontation between the International Monetary Fund and the EU over the existing loan package to Greece. As such the economic outlook is subdued in the short term.
The major economies are currently doing well though and Gross Domestic Product (GDP) has remained steady year on year. Inflation is expected to remain under target and Corporate earnings are improving on the back of investor sentiment becoming more positive.
Fixed Interest Securities
Government Bonds & Gilts
The decision was made to reduce the exposure to short duration UK Gilts as the current yields make it fairly difficult to achieve any return after costs. Instead, the portfolios will allocate more in longer term duration bonds although they are also proving to be fairly expensive after the recent Sterling moves.
We have introduced a new allocation in the portfolios to Overseas Government and Index Linked Bonds. Due to the hints from both the European Central Bank and the Bank of England that there was a consideration to reduce the amount of economic stimulus, the government bond yields rose. The US Federal Reserve has suggested that interest rates are likely to increase later this year which has seen the yields from the US government bonds drop slightly.
We continue to monitor inflation and the interest rate outlook but, other than short term volatility, we still fundamentally believe in Government Debt being an important and irreplaceable element in portfolios.
Corporate Bonds
The compression of credit spread was a significant feature of 2016, with the difference in yield between corporate and government bonds narrowed markedly and remained very low. Investors in Corporate Bonds have therefore been facing lower yields and in turn compensated less for the additional risk taken for investing in Corporate Bonds. This has mainly been due to corporate bond purchase programmes undertaken by the ECB and Bank of England.
However, following the extended period of low growth in this sector, there is some optimism in the global markets along with the expectation of higher inflation. Consequently, Corporate Bond yields are starting to increase slightly although this is not completely the case for UK Corporate Bond performance which is largely limited due to Brexit concerns and a slowdown in domestic growth.
Overall the expectation is for global corporate bond yields to increase in 2017/18 although this will be largely dependent on inflationary reactions to fiscal policies within the various regions.
Property
The UK Real Estate cycle is at a mature stage and expectations of further capital growth are largely expected to be limited although the income production from commercial property still remains attractive. Overseas, European property continues to perform well in a global context – Stronger economic growth and low supply are supporting healthy income growth in this sector. The US market is also showing low vacancy rates across most sectors and due to demand, it is believed for there to be opportunity for rental growth in this sector.
*Extract from the MPC minutes
“At its meeting ending on 14 June 2017, the MPC voted by a majority of 5-3 to maintain Bank Rate at 0.25%. The Committee voted unanimously to maintain the stock of sterling non-financial investment-grade corporate bond purchases, financed by the issuance of central bank reserves, at £10 billion. The Committee also voted unanimously to maintain the stock of UK government bond purchases, financed by the issuance of central bank reserves, at £435 billion.
The MPC set out its most recent assessment of the outlook for inflation and activity in the May Inflation Report. That assessment depended importantly on three main judgements: that the lower level of sterling continues to boost consumer prices broadly as projected, and without adverse consequences for inflation expectations further ahead; that regular pay growth remains modest in the near term but picks up significantly over the forecast period; and that more subdued household spending growth is largely balanced by a pickup in other components of demand.
CPI inflation has been pushed above the 2% target by the impact of last year’s sterling depreciation. It reached 2.9% in May, above the MPC’s expectation. Inflation could rise above 3% by the autumn, and is likely to remain above the target for an extended period as sterling’s depreciation continues to feed through into the prices of consumer goods and services. The 2½% fall in the exchange rate since the May Inflation Report, if sustained, will add to that imported inflationary impetus.”