24 March 2017 /
Asset allocation is a key step in Sandaire’s investment process and, necessarily, we spend much time considering factors that may affect investment returns of different asset classes. Presently we are in a challenging but interesting period and this market update highlights the fundamental factors we are considering.
Political uncertainty abounds in Europe and the Korean Peninsula. The chances of a Le Pen victory remain low and there appears to be a discernible trend of the European Union (EU) bloc girding itself against political offence from the Trump administration. I believe this lowers the risk factor for European assets in the short term, although the market does not seem to be pricing in much risk anyway.
Dealing with North Korea following the recent missile launch close to Japan may pose more risk of potential conflict, as the United States (US) appears to be prepared to take a more confrontational approach. However, for now, I think these risks should have only a low weighting in asset allocation decisions.
It is worth noting the evident political calm in Japan. Notwithstanding an inconvenient whiff of a scandal involving Prime Minister Abe’s wife, who has been linked to a nationalist elementary school in Osaka prefecture, Abe remains very popular and appears likely to be heading for a third term. Assuming the scandal dissipates, as Abe has threatened to resign over the matter, there is optimism that the economic reform programme will continue. Compared to elsewhere amongst the G7 countries, Japan appears to be a haven of political stability and a country pretty much at ease with itself.
Trump’s economic agenda of America first is crystal clear but his economic policy agenda is not. Our attention is focussed on the US budget and his planned replacement of the Affordable Care Act (Obamacare). Progress is slow. ACA replacement has no agreement at present and the Republican plan is to do this before tax reform. The recently announced Trump budget at first appears somewhat dead on arrival. Expectations of an economic boost from fiscal policy are fading and rightly so. The fiscal journey remains a source of potential disruption to risk assets from both an inflationary perspective and a growth disappointment.
Monetary policy in the US is guided by the course of the economy and also the future composition of the key decision-making body, the Federal Open Market Committee. The current administration dislikes the continuation of unusual monetary measures which results in the current very low level of interest rates. Whilst the current Federal Reserve points to rather modest rate increases, the appointment of a new Chairperson may result in an unexpected interest rate outcome. Whilst commentators say fiscal policy is now more important for markets than monetary policy, I believe this may not be the case.
There is little reason to change a central growth forecast for the US economy of between 2% and 3% per annum for the next two years with an inflation rate of between 2% and 3%. The growth risks are equally balanced. Weaker growth could come from faster wage growth due to a tight labour market and therefore faster interest rises. Stronger economic growth could come from fiscal actions and perhaps increased capital spending on fossil fuel-based projects, which had previously been thwarted by Presidential Executive Orders. If pushed, I would argue the former to be more likely than the latter but both are reasonably low odds. Overall the US economy appears to be functioning well at present, and ironically, I believe it is probably best left to its own devices.
European economic growth (excluding United Kingdom (UK)) is quite unexciting with forecasts still sub 2% for the region in 2017. The recent positivity about Europe’s sluggish growth probably reflects a relief that things did not turn out worse when the banks were under enormous pressure last year. Above-trend economic growth expectations in Europe seem inconceivable in the absence of significant policy shifts or structural reform.
UK economic growth must be at risk of slowing down, as it has been held up by largely debt-led consumer spending. The much hoped for fiscal expansion is not happening, as the government vainly clings on to balancing the budget in the medium-term target. Having thought that the Bank of England might need to raise interest rates by at least 25 basis points, the outlook is now less certain and the pound probably remains vulnerable, even though it is cheap on a purchasing power parity basis.
The Japanese equity market has been a favoured market for Sandaire for a while. The recent Wigmore Association meeting in Tokyo gave me an opportunity to compare notes with the group and this reaffirmed our positive stance on Japan.
Following the fears a year ago that China’s debt levels would overwhelm the real economy; these fears have now dissipated, as the authorities pursue a programme of debt restructuring. While risks remain, capital creation continues apace and is benefitting the greater China region generally. Although the path of US interest is higher, this will probably cause only modest headwinds for the highly leveraged Asian economies.
India remains positive both politically (from a stability point of view), with Prime Minister Modi’s BJP great electoral success in Uttar Pradesh, and economically despite the demonetisation programme. The political narrative is increasingly about helping the poor and those left behind rather than promoting India on the global stage. And there is a strong nationalist undertone, but that is reflective pretty much everywhere else in the world.
Apart from valuations, everything appears stable. With frontier markets being promoted there is a perception that investors are chasing these markets. I generally don’t like quotes but this one from Warren Buffett resonated: “People who buy for non-value reasons are likely to sell for non-value reasons. Their presence in the picture will accentuate erratic price swings unrelated to underlying business development”. On our metrics of the Liquidity Preference Model, which monitors interest rate and economic growth trends, the US equity market appears to be in expensive territory which warrants both market engagement and caution. Investors are tapping back into the ‘better’ value markets such as Europe and emerging markets. The still rather benign interest environment is likely to be supportive of this move. Not until fixed income provides a real alternative to equities will equities be seriously challenged.
A secular rise in yields is underway but this will be a slow process unless the Trump administration makes real progress on a stimulatory budget or inflation kicks-in more aggressively than currently thought.
Famous last words, but it does seem that we are entering a period of stability, as the dollar’s upward march is checked. If there is a break-out, it is probably renewed US dollar strength. The policy outlook for the pound is so opaque, that is it is difficult to draw any strong conclusions about sterling’s short or medium-term outlook.
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