While we have made no major changes to our broad asset
allocation in the past month, markets have been anything but quiet.
The strong market performance of 2017 reflected, to a meaningful
degree, investors pricing assets for a much better economic and
earnings environment - but the sharp drawdowns we saw in February
did not, to our minds, reflect a sharp deterioration in this
outlook.
The violent spike in risk aversion was driven by technical
rather than fundamental factors as the combination of a large
shakeout in highly levered volatility vehicles (such as
exchange-traded funds and exchange-traded notes), coupled with
extended investor positioning, drove a sharp increase in equity
volatility and a fall in prices that was not mirrored in other
asset classes - credit markets were notably well behaved during
this period.
We were cautious not to step in the way of large systematic
funds that were liquidating assets, but this 'valuation shock' gave
us the opportunity to increase exposure to favoured markets and
capture the value lost by market participants that had become
forced sellers. To that end, our positive, reflationary economic
outlook for 2018, accompanied by good earnings forecasts and a
sparse risk of recession, point to few fundamental drivers for risk
off markets. That said, the risk of an 'accidental' crisis or
policy mistake has probably increased.
This leaves us with a preference for equities, commodities and
property over core nominal and inflation-linked government bonds
with credit and cash marked at neutral. Within equities, a clear
preference is maintained for Japan, Asian emerging markets and
Europe, each of which is highly operationally levered to ongoing
global reflation. Our recent work has turned to analysing these
positions, with a particular focus on European and Japanese
equities.
Europe
European equities, being procyclical, operationally geared and
international, are well placed to benefit from the current
reflationary global macro environment. We believe rising bond
yields, mounting inflation expectations and a steeper curve are
helpful to European stocks, with the latter factor particularly
helpful for corporate earnings in the financials sector.
Monetary conditions are far from restrictive in Europe and
recession risk is low; indeed, recessions have never occurred in
the region unless real interest rates are at least 2% in the US and
the yield curve inverted. Moreover, manufacturing sentiment
indicators remain strong, while wage pressures (Germany apart) have
yet to emerge, creating a potential 'sweet spot' for companies to
expand profit margins (we are, however, keeping an eye on surveys
indicating that labour is becoming scarce).
On a valuation basis, European equities relative to other
European assets and other equity regions remain compelling. But
among the chief risks are movements in the exchange rate (which
will likely reduce corporate earnings by 3-5 percentage points,
lowering our forecast for 2018 to 10%-12%), and a parallel shift up
in the yield curve.
Japan
Our constructive view on Japanese equities has not changed.
Global demand is the chief driver of corporate earnings and these
are expected to grow by an above consensus 11% in 2018 - we also
expect above-consensus corporate earnings in 2019. Although sudden
and large currency moves could be problematic, especially for large
exporters, we believe companies can adapt to more gradual moves and
Japan only has around a third of its revenue base overseas, which
is relatively modest in a global context.
The broader context for Japanese companies is one of smartly
rising non-manufacturing and manufacturing operating profit
margins. Although these are low by international comparison,
reflecting Japan's higher cost base, the direction of travel is
clearly favourable with plenty of upside as companies increasingly
focus on shareholder returns.
Also, after a period of extreme monetary ease, the Bank of Japan
has shifted from a quantity to quality target and our expectations
are for a modestly higher targeted yield, supported by gently
rising inflation. Japan is no longer a safe haven but a destination
for foreign investors that creates a positive flow support. It
remains our only strongly favoured asset class.
Asset allocation snapshot
Source: Columbia Threadneedle
Investments, as at 13 March 2018.
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