Investment Outlook

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August 29, 2018

Investment Outlook

Tom Elliott

• Improved valuations for equities and credit, a strong U.S economy, and a cautious Fed will all support Wall Street over the coming months
• But the Fed is being cautious for good reason and investors may wish to build cash positions
• The ending of quantitative easing policies around the world will test risk assets, those with richest valuations are most vulnerable
• A diversified multi-asset portfolio remains the best protection against unpredictable markets
Market sentiment: A weaker dollar, on the back of Fed caution, has brought some comfort to investors in risk assets, and a respite to emerging markets. Meanwhile, the risk of NAFTA being torn apart appears to have abated with the U.S and Mexico agreeing on modifications (though putting Canada in a difficult position). 
Further to go for the bull market? Last week saw Wall Street celebrate the longest stock market rally in history (this one started in March 2009). One suspects it has further to go, given that the current defining features of the U.S economy -strong growth and a cautious Fed- are an investor’s dream. This happy combination can be seen in today’s upward revision to second quarter U.S GDP growth estimates, to 4.2%, which comes just a week after Fed chair Jay Powell promised caution over the pace of interest rate hikes next year in his address at Jackson Hole (although he did as good as confirm two more rate hikes this year, in September and December). Furthermore, global stock and credit market valuations are more attractive than at any point this year, thanks to corporate earnings growth outpacing share price growth. 
But while the outlook for Wall Street over the coming months appears good, as we go into 2019 investor sentiment towards the U.S stock market may change sharply. Cautious investors may want to start building up cash positions, and so take advantage of any sell-off. After all, the Fed’s caution is justified: many economists suspect that behind the current GDP growth spurt are temporary boosts to the economy, such as tax cuts and strong exports of goods ahead of the imposition of counter tariffs by America’s trading partners. And a 2% return on USD cash isn’t to be sneezed at.
Then we have political risk, whether over trade negotiations, North Korea, Iran…and the risk of the impeachment of Donald Trump, should the Democrats win control of the Senate in the mid-term Congressional elections. 
But perhaps the biggest risk to investors is the steady draining away of global liquidity, as central banks end or -in the case of the Fed, actually put into reverse- their quantitative easing policies. The chart below, from JP Morgan, nicely illustrates the likely culminative effect on total global liquidity of the current money-creation policies by four of the largest central banks, if current plans are put into effect. We can see from the brown line that the central banks will be net destroyers of money at the start of next year. If there is less money, everything else being equal, its price must rise. The price of money is the interest rate the market is willing to pay. 
This will probably therefore lead to higher bond yields, even if central banks -including the Fed- hesitate about further raising of short term rates. Credit markets appear particularly vulnerable, with a knock-on effect for stock markets as the cost to companies of servicing corporate debt rises. Meanwhile, rising bond yields will put stock prices under pressure.

Europe over the U.S? Tighter global liquidity will hit extended markets first. Cheaper stock markets may be less vulnerable. Although Europe has its own political problems (eg, Brexit and Italy), valuations are cheaper than in the U.S and the current euro zone economic cycle is younger, with the potential for an acceleration of profits growth helped by the 5% fall in value of the euro against the dollar since March. The UK’s FTSE100 index will benefit from a hard, or a ‘no-deal’ Brexit, due to the likelihood of sterling weakening and so boosting the value of overseas earnings when expressed in pounds. 

It’s too soon to be bullish on emerging markets. The underperformance of emerging stock markets this year has improved their valuations, relative to underlying corporate earnings and to developed stock markets. The MSCI Emerging Markets index has underperformed the S&P500 by approximately 16% so far this year. But emerging stock markets remain highly vulnerable to trade wars, and to the tightening of global liquidity as mentioned above. It is therefore too soon to recommend an overweight position relative to a long-term benchmark position (such as the 6% weighting in the illustrative portfolio shown below).

A multi-asset portfolio for the long term. We favour a long-term multi-asset approach to investing, whereby investors choose a suitable combination of global equities and bonds (depending on their risk profile and investment horizon), and leave the portfolio unchanged. Regular re-balancing ensures winners are sold and losers are bought – which financial history, and common sense, supports. The chart below shows a typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor. Note that the chart shows neutral weightings for the long-term investor, it does not incorporate the near-term weighting suggestions of the previous paragraph.

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