Fairey Associates Economic Outlook – June 2018
Following a review of our portfolios for 2018/19 we have made some minor changes to the 2017/18 portfolios. The changes have been in response to updated views on global markets, consideration to the volatility experienced earlier in the year, and thoughts on where we believe growth can still be found over the next twelve months.
In line with last year’s view we still believe it is prudent to have modest growth expectations over the next few years. The last twelve months performance has exceeded expectations but volatility also increased over the same period. For 2018 and beyond, a view of higher risk and lower returns is widely predicted.
Many economists believe the biggest risk to Global Markets will in part be due to inflation risks within the US and the potential tightening of Quantitative Easing in the Eurozone area. Interest Rate rises are expected globally however any rises are thought to be small and incremental in nature and have already been ‘priced in’ to asset values.
This document compliments our Investment Manual 2018/19 and represents our views at the current time. We continue to monitor the performance of various sectors. Should we feel the need to change our asset allocation, we are able to recommend this to you.
UK Markets
The outlook for the UK economy still remains uncertain given the lack of clarity over the UK’s departure from the EU and leaving the Customs Union. Ultimately, the major effects of Brexit will only be felt once we actually leave the EU at the end of the transition period in December 2020.
In May 2018 the Bank of England held interest rates at 0.5%. A rate rise of 0.25% had been widely predicted by the markets but due to a drop in CPI to the lowest level in more than a year, lacklustre GDP growth and a raft of poor economic data the decision was made to delay any further increases to the Base Rate.
In line with our views last year, we have made further modest reductions for the allocation to UK equity holdings across our portfolios. We believe that although our domestic market defied many commentators last year, the UK markets are still at risk of political uncertainty with many investors remaining wary until a clearer picture of our strategy to leave the EU (including the Customs Union) unfolds.
Global Markets
Economic growth in the developed markets are due to remain moderate in 2018 with the strong emerging market growth dampening slightly. One of the key areas to watch globally is the unemployment rates as they continue to decline further across many economies (reaching multi-decade lows for some regions). The UK is expected to continue to lag behind its’ European counterparts but on a global perspective, the US, Europe and Japan should help offset the UK’s weak performance.
It is anticipated that the factors supressing global inflation will subside and there is now a higher probability of higher than trend inflation (of course it is important to remember that inflation has remained stubbornly low for some time) with tightening labour markets, stable global growth and commodity prices likely to push these global inflation rates.
The pick up of cyclical inflation could lead to a more ‘aggressive’ path to normalising global monetary policy with the most likely candidate to lead the way being the US (the Federal Reserve is projected to raise interest rates to 2% by the end of 2018). The ECB is still a little way off raising interest rates and starting its policy on quantitative tightening.
Overall, expectations for growth globally are down from 2017, but increased volatility is also on the radar for many economists.
US
Out of all geographical regions, we have continued to allocate a higher proportion to US holdings than any other region. The positive case for the US focuses on the continuing health of the economy. Job creation remains strong, the housing market remains healthy and corporate earnings data continues to be reassuring. Against this we are mindful that interest rates could increase more rapidly than expected and there are uncertainties around the Fed’s unwinding of its balance sheet. We are also mindful that the early signs of market protectionism could start to have a knock on effect for certain sectors within the American economy (with Steel tariffs being a clear example of this).
Our expectations for growth remain modest for the next few years but we are also aware that volatility is likely to increase (as demonstrated earlier this year).
Asia Pacific
Asian equity markets have recently had a small boost following the easing of concerns of a trade war between the US and China and the positive outcomes of the inter-Korea summit that could see a peace treaty signed and a formal end to military conflict (and potentially opening up the North Korean market). The largest contributors to Asia’s earnings growth expectations continue to Korean technology companies.
Fund managers believe there is still longer term growth potential and the current valuations are not yet at ‘peak’ however with 2017 witnessing a remarkable year for Asian equities, more modest returns are projected over the next twelve months.
Japan
Following the inclusion of Japan into our portfolios last year, we continue to believe there is opportunity for growth in this region (even though there was a correction in the Nikkei Index at the beginning of February) as Japanese shares continue to be less highly rated than those in Europe and the rest of Asia. The Japanese GDP has been positive for eight consecutive quarters – this is the longest consecutive run since the peak of Japan’s economic boom in 1989.
Japanese companies are now increasing capital investment, looking to improve production efficiencies and this is creating a squeeze on the jobs market with unemployment at its lowest point since 1993. As a result employment income growth is increasing and consumer confidence is at historically high levels. As such, Japanese inflation is starting to gradually increase which is a real turning point for the Japanese economy after a generation of deflation.
Emerging Markets (including China)
Following a decade of credit expansion, China’s credit profile has now stabilised and although this bodes well for China’s medium term goal of maintaining financial stability it is likely to impact negatively on near term growth. Growth in household consumption remains resilient and has outpaced that of investment and exports. Disposable income has provided a boost to the tertiary sector to help balance out some of the decline in the secondary industrial sector. Overall, economists are projecting growth of c. 5% - 6% in china for 2018/19.
The slowing of China’s economy is one of the main risks for the emerging markets due to the reduction in world commodity markets however now that China and Russia have emerged from recession, cyclical stocks could help withstand the slowdown. Another risk is the potential faster pace of monetary normalisation in the US and other developed economies could also impact growth expectations. A sudden movement of the US dollar could damage the balance sheets of emerging market companies who hold high levels of corporate debt denominated in foreign currencies.
Economists expect Latin America to see continuing improvements in growth as well as emerging Asia (the forecasts of which are more robust). Overall, the varied outlook of the emerging markets is projecting growth of c. 5%.
Europe
We believe the outlook for the euro-area economy over the next twelve months is the strongest we have seen since the financial crisis. Economists anticipate that growth will be just under 2% for 2018 with the political risks of 2017 somewhat diminishing.
All countries (excluding the UK) have shown growth in the last twelve months and unemployment is steadily falling towards ‘an equilibrium rate’ although Eurozone core-inflation still remains stubbornly low. Economists also do not expect the European Central Bank (ECB) to start increasing interest rates in the next year due to their commitment to hold on until well past the end of its quantitative easing program.
Fixed Interest Securities
Government Bonds & Gilts
The decision was made to reduce our exposure to government bonds and gilts by c. 10% this year although we still fundamentally believe in the Government Debt being an important and irreplaceable element in portfolios. Government bonds are largely dependent on central bank policy and credit and we believe this is cause to exercise a more cautious stance as Central Banks have been slow to normalise monetary policy to date.
The current Government Bond yields are a reflection of both low inflation and slow growth, along with the impact of quantitative easing and the Bank of England still holding over a third of outstanding gilt issuance.
Within our UK gilt exposure we have allocated the same proportion to index linked gilts and have remained committed to gaining exposure to short, medium and long term gilts by using index tracking rather than actively choosing a determined duration.
In order to diversify our exposure to government bonds, we have allocated a higher percentage to global fixed income securities, recognising that regions are in differing points in their quantitative easing measures or economic recovery. Overall, we hope this will reduce the volatility of this asset class.
Corporate Bonds
Investors in Corporate Bonds have been facing lower yields and in turn compensated less for the additional risk taken for investing in Corporate Bonds over the last few years. This has mainly been due to corporate bond purchase programmes undertaken by the ECB and Bank of England.
With the continued expectation for higher global inflation, there is still some optimism in the global markets and as such Corporate Bond yields may start to show signs of improvement although this may continue to be stunted in the UK market which is largely limited due to Brexit concerns and poor market data of late.
Direct 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 a strong alternative to Government and Corporate Bonds where yields are supressed. The near-term outlook for returns in likely to be more modest in comparison to 2017 with rental growth looking sluggish and the average annual returns for bricks and mortar property reducing to 4 – 5% pa. Concerns over Brexit and future tenancy rates (in particular London) continue to play a part in the dulled outlook of the UK direct property sector.
Indirect Property
Sector specialists expect 2018 to be another year of relative underperformance for the US real estate sector with Canada showing slightly better financials for Real Estate Investment Trusts. Along with the US, it is also expected that the Australian REIT sector will also continue to underperform. Asia and Europe are projected to achieve positive results with Hong Kong, Singapore and Japan showing positive real estate data.
In line with last year’s view we still believe it is prudent to have modest growth expectations over the next few years. The last twelve months performance has exceeded expectations but volatility also increased over the same period. For 2018 and beyond, a view of higher risk and lower returns is widely predicted.
Many economists believe the biggest risk to Global Markets will in part be due to inflation risks within the US and the potential tightening of Quantitative Easing in the Eurozone area. Interest Rate rises are expected globally however any rises are thought to be small and incremental in nature and have already been ‘priced in’ to asset values.
This document compliments our Investment Manual 2018/19 and represents our views at the current time. We continue to monitor the performance of various sectors. Should we feel the need to change our asset allocation, we are able to recommend this to you.
UK Markets
The outlook for the UK economy still remains uncertain given the lack of clarity over the UK’s departure from the EU and leaving the Customs Union. Ultimately, the major effects of Brexit will only be felt once we actually leave the EU at the end of the transition period in December 2020.
In May 2018 the Bank of England held interest rates at 0.5%. A rate rise of 0.25% had been widely predicted by the markets but due to a drop in CPI to the lowest level in more than a year, lacklustre GDP growth and a raft of poor economic data the decision was made to delay any further increases to the Base Rate.
In line with our views last year, we have made further modest reductions for the allocation to UK equity holdings across our portfolios. We believe that although our domestic market defied many commentators last year, the UK markets are still at risk of political uncertainty with many investors remaining wary until a clearer picture of our strategy to leave the EU (including the Customs Union) unfolds.
Global Markets
Economic growth in the developed markets are due to remain moderate in 2018 with the strong emerging market growth dampening slightly. One of the key areas to watch globally is the unemployment rates as they continue to decline further across many economies (reaching multi-decade lows for some regions). The UK is expected to continue to lag behind its’ European counterparts but on a global perspective, the US, Europe and Japan should help offset the UK’s weak performance.
It is anticipated that the factors supressing global inflation will subside and there is now a higher probability of higher than trend inflation (of course it is important to remember that inflation has remained stubbornly low for some time) with tightening labour markets, stable global growth and commodity prices likely to push these global inflation rates.
The pick up of cyclical inflation could lead to a more ‘aggressive’ path to normalising global monetary policy with the most likely candidate to lead the way being the US (the Federal Reserve is projected to raise interest rates to 2% by the end of 2018). The ECB is still a little way off raising interest rates and starting its policy on quantitative tightening.
Overall, expectations for growth globally are down from 2017, but increased volatility is also on the radar for many economists.
US
Out of all geographical regions, we have continued to allocate a higher proportion to US holdings than any other region. The positive case for the US focuses on the continuing health of the economy. Job creation remains strong, the housing market remains healthy and corporate earnings data continues to be reassuring. Against this we are mindful that interest rates could increase more rapidly than expected and there are uncertainties around the Fed’s unwinding of its balance sheet. We are also mindful that the early signs of market protectionism could start to have a knock on effect for certain sectors within the American economy (with Steel tariffs being a clear example of this).
Our expectations for growth remain modest for the next few years but we are also aware that volatility is likely to increase (as demonstrated earlier this year).
Asia Pacific
Asian equity markets have recently had a small boost following the easing of concerns of a trade war between the US and China and the positive outcomes of the inter-Korea summit that could see a peace treaty signed and a formal end to military conflict (and potentially opening up the North Korean market). The largest contributors to Asia’s earnings growth expectations continue to Korean technology companies.
Fund managers believe there is still longer term growth potential and the current valuations are not yet at ‘peak’ however with 2017 witnessing a remarkable year for Asian equities, more modest returns are projected over the next twelve months.
Japan
Following the inclusion of Japan into our portfolios last year, we continue to believe there is opportunity for growth in this region (even though there was a correction in the Nikkei Index at the beginning of February) as Japanese shares continue to be less highly rated than those in Europe and the rest of Asia. The Japanese GDP has been positive for eight consecutive quarters – this is the longest consecutive run since the peak of Japan’s economic boom in 1989.
Japanese companies are now increasing capital investment, looking to improve production efficiencies and this is creating a squeeze on the jobs market with unemployment at its lowest point since 1993. As a result employment income growth is increasing and consumer confidence is at historically high levels. As such, Japanese inflation is starting to gradually increase which is a real turning point for the Japanese economy after a generation of deflation.
Emerging Markets (including China)
Following a decade of credit expansion, China’s credit profile has now stabilised and although this bodes well for China’s medium term goal of maintaining financial stability it is likely to impact negatively on near term growth. Growth in household consumption remains resilient and has outpaced that of investment and exports. Disposable income has provided a boost to the tertiary sector to help balance out some of the decline in the secondary industrial sector. Overall, economists are projecting growth of c. 5% - 6% in china for 2018/19.
The slowing of China’s economy is one of the main risks for the emerging markets due to the reduction in world commodity markets however now that China and Russia have emerged from recession, cyclical stocks could help withstand the slowdown. Another risk is the potential faster pace of monetary normalisation in the US and other developed economies could also impact growth expectations. A sudden movement of the US dollar could damage the balance sheets of emerging market companies who hold high levels of corporate debt denominated in foreign currencies.
Economists expect Latin America to see continuing improvements in growth as well as emerging Asia (the forecasts of which are more robust). Overall, the varied outlook of the emerging markets is projecting growth of c. 5%.
Europe
We believe the outlook for the euro-area economy over the next twelve months is the strongest we have seen since the financial crisis. Economists anticipate that growth will be just under 2% for 2018 with the political risks of 2017 somewhat diminishing.
All countries (excluding the UK) have shown growth in the last twelve months and unemployment is steadily falling towards ‘an equilibrium rate’ although Eurozone core-inflation still remains stubbornly low. Economists also do not expect the European Central Bank (ECB) to start increasing interest rates in the next year due to their commitment to hold on until well past the end of its quantitative easing program.
Fixed Interest Securities
Government Bonds & Gilts
The decision was made to reduce our exposure to government bonds and gilts by c. 10% this year although we still fundamentally believe in the Government Debt being an important and irreplaceable element in portfolios. Government bonds are largely dependent on central bank policy and credit and we believe this is cause to exercise a more cautious stance as Central Banks have been slow to normalise monetary policy to date.
The current Government Bond yields are a reflection of both low inflation and slow growth, along with the impact of quantitative easing and the Bank of England still holding over a third of outstanding gilt issuance.
Within our UK gilt exposure we have allocated the same proportion to index linked gilts and have remained committed to gaining exposure to short, medium and long term gilts by using index tracking rather than actively choosing a determined duration.
In order to diversify our exposure to government bonds, we have allocated a higher percentage to global fixed income securities, recognising that regions are in differing points in their quantitative easing measures or economic recovery. Overall, we hope this will reduce the volatility of this asset class.
Corporate Bonds
Investors in Corporate Bonds have been facing lower yields and in turn compensated less for the additional risk taken for investing in Corporate Bonds over the last few years. This has mainly been due to corporate bond purchase programmes undertaken by the ECB and Bank of England.
With the continued expectation for higher global inflation, there is still some optimism in the global markets and as such Corporate Bond yields may start to show signs of improvement although this may continue to be stunted in the UK market which is largely limited due to Brexit concerns and poor market data of late.
Direct 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 a strong alternative to Government and Corporate Bonds where yields are supressed. The near-term outlook for returns in likely to be more modest in comparison to 2017 with rental growth looking sluggish and the average annual returns for bricks and mortar property reducing to 4 – 5% pa. Concerns over Brexit and future tenancy rates (in particular London) continue to play a part in the dulled outlook of the UK direct property sector.
Indirect Property
Sector specialists expect 2018 to be another year of relative underperformance for the US real estate sector with Canada showing slightly better financials for Real Estate Investment Trusts. Along with the US, it is also expected that the Australian REIT sector will also continue to underperform. Asia and Europe are projected to achieve positive results with Hong Kong, Singapore and Japan showing positive real estate data.
