Markets have made strong upwards progress so far in the year, though unlike in prior years earnings growth is coming through sufficiently strong to keep multiples stable. This is providing some comfort to us though we do wonder how long this EPS spurt can persist. Economic growth is unexciting but at least it is steady and broadly based. Recent data suggests that the US economy may be softening a tad but this is being offset by the pick up in Europe. Equity market valuations remain expensive but are unlikely to come under severe threat whilst conditions remain benign. This does not preclude the possibility of a summer correction and after the recent run, some back filling is now overdue.
We are baffled how interest rates can be maintained at negligible levels as the spare capacity created by the financial crisis appears close to spent. Experience tells us that we should be seeing wage pressure with inflation following on at its heels, though there is scant evidence of this happening. The slow down in productivity is another mystery and although arguably this predates the financial crisis, the scars created by the crisis may have deepened the trend. Demographics is a likely candidate cause of the productivity slowdown but we should not ignore the profound impact that the technological revolution is having on the way that people are living their lives. Amazon is changing the way we shop, Priceline et al is changing the way we travel and Uber is changing the taxi industry. Service businesses such as these are major employers and economies are adapting in ways that are difficult to envisage. The 5 largest companies in the global index are: Apple, Microsoft, Amazon, Facebook & Exxon. And Exxon only makes the list because Google split out Alphabet. This is a remarkable indictment of the changes that are occurring in our world (or alternatively just of loopy valuations).
The financial crisis blew developed economies into unchartered territory and the global central bankers have been left with an unenviable job to navigate through this. However, with the UK 10 year bond now at less than 1%, our call here is an easy one. The Conservative Campaign Headquarters has made such a Horlicks of the election campaign one wonders if they've deliberately fermented Corbyn's socialist poison in order to separate Labour from the middle ground. Ignoring conspiracy theories, we must conclude that the electorate is shifting to the left. The re-emergence of the hard left in UK politics should hit gilt holders like a dose of smelling salts but incredibly yields continue to tighten. Perhaps investors are comparing British bonds to those in Japan, where a 5% deficit and a 15 digit national debt hasn't deterred JGB holders from forgoing any interest at all. We won't be committing client capital to either market! Equities are a harder call to make. From a historical perspective, they are expensive yet compared to a ludicrously priced bond market they look almost a bargain. The strength in the bond market and the improving trend in EPS leaves us in a position where we may neutralise our caution towards equity markets if we see a summer sell off.
We are now through the dangerous part of the political cycle in continental Europe. The German elections are unlikely to impact markets. Italy will go to the polls by next May but a snap election before then cannot be discounted. Dissatisfaction with the euro is growing inside Italy and the euro sceptic Five Star Party could easily end up as the largest party. However, the term 'political competency' does not spring readily to mind for Five Star and may indeed be oxymoronic when applied to most politicians in Italy. Even if Five Star win, we doubt that they will be in a position to engineer an Italian exit from the euro. With the European economies enjoying a cyclical uplift we can no longer justify extreme caution towards the equity market. Caution seems more appropriate as the structural problems haven't gone away. We are loath to chase after European equities following their recent jump in price and we will not look to lift exposure here in the immediate future.
Our managers are telling us that Japan and its corporations are doing quietly well. The economy is growing once more, the corporate governance reforms are having an impact on management albeit at a gradual pace and the market's 2.3% yield places it close to the global average. Foreigners, often the swing investor in the market, are on the side lines. The market is also significantly cheaper than Europe and appears attractively priced. This is a market that typically does well during global expansionary periods and the activity surrounding the preparations for the Tokyo Games in 2020 could also help sentiment. An additional attraction comes from the protection that yen exposure could bring to our portfolios.
We established positions in high yield bonds in December 2015 following a blow out in yields. Yields have since fallen as expected and left us sitting on a double digit gain. It is tempting to persist with the position given the benign outlook and bank the reasonable income on offer but sentiment in this asset class can turn rapidly. Meanwhile, lower yields and less stringent scrutiny by lenders has increased the risk. We can no longer justify favouring this sub asset class.
Our contact with asset managers has highlighted a potential opportunity in emerging market debt. After a rocky few years, prices are rallying and yields remain attractive. We structurally favour the emerging markets region, which should benefit from the synchronised growth in the global economy. Tighter US monetary policy is not a help though the recent weakness in the dollar should help offset this. This appears to be an attractive alternative to high yield bonds.
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