What changed for you from an asset allocator's perspective over the course of 2017?

We entered 2017 with a negative view on prospective risk-adjusted returns across asset classes, a view we had held since mid-June 2016, just before the UK's EU referendum. Early in the year we marked higher our risk tolerance, for two chief reasons. First, it was increasingly evident that the global corporate sector had turned a corner after five to six years of profits recession, with punchy earnings and analyst earnings forecasts. Second, and supporting corporate margin expansion, was the growing breadth of global economic recovery. Looking back at 2017, which was littered with prospective risks, the most striking development was that very little happened.

We turned more constructive on equities over the course of 2017, starting with an upgrade to Europe in March, then equities overall in early May. We have strongly favoured Japan since October. The global nature of current economic expansion benefits particularly markets like Japan and Europe that have high operational leverage, ie high fixed, relative to variable, costs to the global industrial cycle.

The other change was turning strategically neutral on the US dollar at the start of the year, and then in September turning more cautious. I tend to think of the dollar in context of a 'smile': the dollar tends to do well if either the US is outperforming the rest of the world or the world is in recession. We presently have neither scenario, so the dollar sits at the 'bottom' of the smile rather than at either positive 'corner', while other currencies like the euro look more attractive.

What did not change this year is our caution towards long duration assets, especially core government bonds, where we remain resolutely underweight or short of across desk strategies.

In 2017 we have seen near-time or all-time highs across global equity markets. Can equity outperformance continue?

Equities have delivered 60%-160% returns in local terms over the past five years, a period associated with unexciting real economic growth of 1.5%-2.5%. So far this year, volatility-adjusted returns achieved by global stock markets are the highest in two decades, and valuations on some measures appear full. At the same time, risks are not insignificant: for example, a decade of quantitative easing is giving way to quantitative tightening; geo-political threats abound; deglobalisation pressures persist (Brexit, NAFTA), etc. But we still believe equities offer the prospect of strong risk-adjusted returns in 2018. Why?

Significantly, after a period when total returns in equities were driven entirely by valuation - ie we were paying more and more for less and less - returns are now almost entirely driven by improving margins and sales. Equities are rising for the "right" reasons: upside participation in rising economic growth and corporate profits. To be sure, earnings expectations for this year and next have not only held up but are rising, ending the strong gravitational pull seen for the past decade. Until this year, each year 10%-15% 24-month EPS growth expectations dissolved into flat or even negative earnings as the forecast period drew closer. The evolution of 2017, 2018 and 2019 earnings expectations have bucked this trend. As a result, equity rerating has lagged other risk asset moves: for example, forward earnings yields on global equities have not followed high yield corporate bond yields tighter. Our own forecasts suggest this continues, with expectations of 10%-15% EPS growth across major equity regions in the next 12-18 months.

Simply put, notwithstanding fuller valuation, equities offer an attractive premium that is not present in other assets carrying similar risk. We capture this premium in our strategies.

Which areas within global equities are you most bullish on for 2018?

Areas where we find the greatest opportunities in equities are Japan, Europe and Asian emerging markets, with Japan favoured most. EMEA asset allocation strategies at Columbia Threadneedle Investments have been overweight/invested in Japanese equities since the summer of 2013, a period associated, uniquely for Japan, with both good performance and cheapening relative valuations on strong earnings delivery. Despite a stellar 20% year-to-date total return at the time of writing, Japanese stocks continue to trade at a discount to global stock indices. With increased strength in bottomup corporate earnings; evidence of ongoing corporate reform driving better shareholder returns; firm economic expectations, with our forecasts consistently ahead of a rising consensus; receding political risks; and high operational leverage of Japan Inc to synchronous global economic improvements, Japan is where we see top risk-adjusted equity returns in 2018.

Like Japan, Europe also benefits from high operational leverage to the current global upswing. Margins have the scope to rise smartly from still low levels, while earnings continue to deliver on punchy expectations. Asian emerging markets, meanwhile, offer attractive valuation, strong earnings potential and ameliorated risks vis-à-vis 18 months ago.

Commodities bounced back somewhat in 2017. What future do you see for the asset class going forward and how do commodities help you as an asset allocation manager?

Commodities can play an important role for asset allocation portfolios, as they tend to be driven by demand and supply considerations rather than broader risk sentiment. The beta to risk assets is highly unstable, in other words, offering diversification for portfolios invested across asset classes.

We have favoured commodities since September 2016, anticipating a broad-based rally on favourable supply and demand dynamics. At present we are seeing strong demand across the board, particularly from China and other Asian emerging markets as economic recovery continues apace. Supply discipline has, for a variety of reasons, increased, leaving many base metals markets in particular at or near net deficit after years of oversupply. In oil markets, shale producers are unable to come onstream as quickly as they did in 2011-12, while demand is growing at a healthy clip. A softer US dollar has also been helpful, and while a sharp rise in the oil price might scupper the party, that's not what we anticipate. On balance, oil at $60 feels like a supportive level.

Can Chinese growth continue to impress and what might drive it in 2018?

China has been attempting to rebalance its economy away from exports and investment, and towards domestic demand, for several years on the trot. It appears to have achieved this with remarkable success: real economic growth has slowed, from low- to mid-teens post the GFC down to 6%-6.5% in 2017, but with domestic demand driving the lion's share and few signs of a sharper correction in the pipeline. China Inc has moved up the value chain, creating opportunities for other emerging markets. Our base case for 2018 is 'steady as she goes' for China, with an historically lower, but better quality, growth outcome; China continues to underpin around a third of global GDP growth forecasts.

Further out, on a five-year view, our concern remains how China finds its way out of its "RMB Trilemma" - which it must. It is well-proven in economics that a country can only successfully manage two of the following three variables simultaneously: the exchange rate; movements of capital; and independent monetary policy. To be sure, sporadic Chinese efforts to liberalise the currency have been challenging; the capital account is not fully sealed, with up to 2% of banking system assets leaving the country in times of stress; and attempts to fine tune domestic policy have often been confusing, rather than reassuring, to global investors.

Growth, in the meantime, is steady at a slower and more sustainable pace, and the dashboard of indicators we monitor for the Chinese economy shows few signs of stress. As with other countries, a rise in economic productivity would allow China to move up the productivity frontier, bailing everyone out. China could also, of course, allow its currency to be more flexible with a greater role for market forces.

It feels as though the credit cycle is nearing its end. What are your thoughts on credit and fixed income more generally going forward?

We are neutral on credit at present, and no longer have a preference for European high yield over investment grade. As discussed above, credit carries less risk premium than, for example, equities; we are also at a point in the global economic cycle that favours equities over credit.

We remain negatively inclined towards long-duration, richly valued core government bonds, particularly against a backdrop of rising discount rates and quantitative tightening/tapering. Both short rates and term premia embedded in government bonds appear too low. Certainly, from an asset allocator's perspective, government bonds have a very limited role in portfolios; indeed, a combination of equities and cash appears more appealing than equities and bonds on an ex-post efficient frontier.

Reflecting these views, our asset allocation portfolios are running with very light duration: 1.2 years in our Threadneedle Dynamic Real Return strategy, for example.

Summary

Goldilocks-like economic conditions of the past 12-18 months have boosted most asset prices, with Sharpe or volatility-adjusted returns at or past the highs of the past 20 years in many cases. At the same time, risks have not gone away: central banks are tightening their monetary belts after a decade of easing. Politics will be back in focus early next year in Europe and several EMs, and we are investing in a world of potentially rising, not falling, national borders.

Yet our job is to invest through these uncertainties, and capture attractive risk premia where we find them to compensate us for these challenges. It is in this context that we have increased equity weightings through 2017, notwithstanding fuller valuations. At the same time we continue to run our multi-asset portfolios with very light duration, with UK commercial property, commodities and short duration credit as our preferred sources of diversification.

Download PDF