As we move into 2018 we have spent some time evaluating the work we performed last year, as well as revisiting our current asset allocation positioning. 2017 was strong across multi-asset portfolios, both managed and unconstrained, with asset allocation decisions making a meaningful contribution to total returns. For managed funds, asset allocation accounted for about half the excess return - greater than the historical average of one-third.

For unconstrained funds, asset allocation continued to dominate returns but was boosted by stock selection during the course of the year. Continued exposure to risk during the past two years has also proven to be of benefit.

Looking ahead, we have preference for equities, commodities and UK commercial property, with each marked at 'favour', alongside a dislike for government bonds - both nominal and index-linked. We are neutral credit and cash. We also believe prospective returns to risk are at neutral, as the decade of quantitative easing policies that has lifted risk assets begins to reverse, flattening the line between expected risk and reward across asset classes.

Drilling down further into individual asset classes, we believe equities should outperform on a risk-adjusted return basis, as corporate earnings are supported by strong macro-economic data. While aggressive tightening by central banks (ahead of our own and market expectations) could hurt equity markets, our current underweight position in government bonds (which remain at the wrong level, given global growth and inflation trends) should act as a buffer. UK commercial property is also expected to do well: in contrast to government bonds it offers a healthy yield, favourable valuations and a real income stream.

So to credit, also set at neutral, as we balance late-cycle concerns and full valuations against central bank policies and fair fundamentals. Within credit, emerging market debt is favoured, we are neutral on investment grade, and dislike European high yield, reflecting the asymmetry of expected spread moves. Finally, cash sits between gaining as a hard asset with full valuations elsewhere, and losing from its similarity to short-dated government bonds - all in, a neutral allocation.

Evolving views

Our views are, of course, always evolving and we are monitoring closely how current positive economic trends relate to our asset class positioning. While we are seeing rising macro-economic forecasts as synchronised global growth continues, we must ask ourselves how long and on what trajectory corporate earnings will continue. How much potential is there for low margins in Europe and Japan to move markedly higher over 2018? What impact will capital expenditure and wage developments have on corporate margins more broadly? And what risks will Brexit present?

In China, a region which remains perennially on our radar, wage growth ticked higher to 8.8% year-on-year in 2017, according to Macrobond, and working populations are now in medium-term decline. But productivity improvements appear to be overwhelming this to deliver higher levels of corporate profitability. China's current account surplus is being eroded as a percentage of GDP, but FX reserves are building and the shift away from counter-cyclical adjustments to the renminbi shows a degree of confidence in the currency on the part of state authorities. We are only three years into a decade-long realignment of state-owned enterprises and believe China's improving profitability trends are not yet being fully recognised.

That said, medium-term challenges remain: not least China's 'trilemma', which we have spoken about previously. The state has to slow the pace of credit growth to at or below the pace of nominal GDP growth - without derailing the economy - so that the managed currency regime can persist in concert with an independent monetary policy. Some success is being recorded here, and Chinese policymakers are continuing to walk the narrow path towards a successful economic rebalancing away from investment-led growth and towards a consumer economy.

As for emerging markets, we currently hold a relatively upbeat view of the region - but not positive enough for us to change our neutral position. In EM debt, we see four key supports: a better macro-economic backdrop, with improving growth and trade and contained inflationary pressures; a supportive developing markets macro picture; attractive valuations; and a weaker US dollar, which should encourage further capital inflows into EM. However, partly because the environment in which EM debt does well is the same one in which our other reflation plays (such as European, Japanese and Asian emerging market equities) are expected to perform, we have not changed our stance; and we are generally cautious on spread assets in the context of rising core government bond yields.

Asset allocation snapshot

Source: Columbia Threadneedle Investments, as at 26 January 2018.

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