Outlook

01 April 2017

Q2 2017 UPDATE

By London & Capital

GLOBAL MACRO OVERVIEW

The cyclical cheer that gripped markets post-Trump victory continued into the first quarter of 2017, even though the delivery on promised economic policy was pretty poor. Interestingly, the potential for higher US interest rates, Brexit and Frexit concerns were all parked on the side-lines as these were all outweighed by the focus on a stronger and synchronised global economic recovery. There is little to suggest that the “blue skies” focus on underlying economic strength will fade any time soon.

We re-iterate our view that the cyclical upturn remains intact for the time being, providing a positive backdrop for risk markets but also note that key structural undercurrents are increasingly being ignored. Geo-political issues could also increasingly play a pivotal role given the significant shift in President Trump’s foreign policy in recent weeks (intervention in Syria, worsening relations with Russia and thawing of relations with China to list a few).

This document will cover our main views for the rest of the year, and the implications for asset classes.

 

Global Macro Outlook

So far 2017 has played out as expected:

‧ Stronger synchronised global economic growth

Inflation normalisation

Valuations continuing to be stretched as investors react to the economic backdrop

Looking ahead, a few other key aspects are expected to come into focus:

Monetary policy normalisation

‧ Bond market normalisation

Trumponomics stuck in neutral

Economic sentiment has undoubtedly improved across developed and emerging economies as seen by a host of confidence data, not just in the major developed economies but also across a wide swathe of key emerging economies. Even the Eurozone has managed to join the party, adding to the underlying strength in the US and UK. As a result, the wide output gaps are finally beginning to narrow, throwing into focus the likelihood of an end to the emergency era of low interest rates coupled with central bank asset purchases.

In tandem with this, inflation has also begun to normalise, with developed economy prices edging higher towards the target rates set out by the Central Banks, whereas in the emerging economies the trend is for lower price pressures.

 

Developed Markets Outlook

USA

The recent pattern of US economic growth is set to repeat yet again in 2017, with a weak first quarter followed by a significant bounce back in the remainder of the year. The seasonal impact remains a pervasive influence, with Q1 GDP growth expected to be just below 1%. It would seem that both consumption and export growth patterns continue to be influenced by the first quarter seasonality even though the underlying dynamics are relatively strong.

The US cycle is mature and there is little to suggest that this will not be extended well into 2018. The economy should grow at 2% to 2.5% in real terms in 2017 (vs 1.6% in 2016). The outlook for 2018 is a little more uncertain now as a number of fiscal measures that had been promised have failed to appear. Nevertheless, growth should still be above 2%, i.e an expansion well into 8 years. This uncertainty is largely due to the fact that both the tax reform package (baseline case of tax cuts eventually worth $1 trillion) and infrastructure spending (also worth almost $1 trillion over time) have got stuck. It would seem that the divisions within the Republican Party that led to the debacle over the Obamacare reform seems to have put most policy initiatives on hold. However, the House and the Ways Means Committee is still putting a framework together which may yet yield a significant fiscal boost in 2018.

High frequency data has generally been positive. The labour market in particular is showing widespread strength. Employment growth is averaging close to 200k (not bad for such a long expansion cycle), the unemployment rate is below 5%, the labour participation rate has begun to edge higher (a sure sign of economic confidence), measures of labour tightness are rising and wages are also gradually trending upwards. Consumer data has been a little more mixed and in particular, auto sales has trended lower. However, a very positive balance sheet impact (from the rise in the stock market and higher house prices) should remain supportive.

On the monetary front, the Fed raised rates by another 25bps in March but rather surprisingly stuck to the gradual rate hike path and left the dot path – the Federal Open Market Committee (FOMC’s) rate projections – unchanged despite higher growth expectations. The market-based implied interest rate path is now more or less in line with the Fed’s own expectations. We expect another 2 rate hikes this year and another 3 hikes in 2018, although this may well be tempered by any erosion of the Fed’s balance sheet.

The Fed has now begun to map out the eventual balance sheet adjustment as it finally weans off the asset purchase programme. There was detailed discussion at the March meeting, implying that the Fed will provide clear forward guidance and that the most likely timing for a balance sheet reduction would be the final quarter of this year. The FOMC is leaning towards halting principal and coupon reinvestments simultaneously. Of course, such a move will have implications for interest rates as the Fed is unlikely to want to combine a series of rate hikes with a balance sheet reduction. It may well mean that the Fed could be on hold through 2018.

US trade protectionism, a potential negative, still lingers in the background but as with all policy initiatives there is a great deal of uncertainty. The most recent comments from President Trump suggest that China is no longer seen as the great currency manipulator and even though the US has pulled out of the Asia-Pacific Trade Deal, the re-negotiation of The North American Free Trade Agreement (NAFTA) does not seem to be as divisive as initially feared. But of course there could be another volte-face ahead.

 

UK

The UK economy continues to defy expectations of a Brexit led slowdown, with neither consumers nor businesses having meaningfully adjusted their behaviour in the wake of the vote. UK GDP grew by 0.6% in the quarter immediately following the referendum, with retail sales and consumer credit both growing at their fastest rate in over a decade in Q4 2016. The momentum still looks relatively strong and we should see UK growth at around +1% in 2017.

Most forecasters expect uncertainty levels to rise now that Article 50 has been triggered but Prime Minister May seems to have a relatively pragmatic and constructive view which has partially softened the public negotiations. It would be foolhardy to expect a smooth transition process given the various Eurozone political hurdles that the UK could still face. It is exceptionally difficult to provide a definitive economic outlook but economic simulations based on various trade relationships suggest either little or no economic impact or a recession on a worst case outcome.

There are still two key questions for the post-Brexit vote outlook for Britain’s economy as the process gets underway. One is the response of consumers and second the response of businesses.

We expect consumption to respond to firstly higher inflation and the expected squeeze on real incomes, and secondly the impact on saving behaviour if the negotiations turn negative. The squeeze on real incomes is exacerbated with the lack of nominal income growth and we must remember that when we had a squeeze on real incomes (between 2010 and 2012) consumer spending slowed to a crawl, albeit the squeeze was far greater than likely this time round. In addition, as long as the labour market remains strong it will be a supportive factor as will the housing market.

Whether it does so this time depends partly on the second question; the ability of the government to keep business on side as it embarks on Brexit, and thus to maintain confidence. If not, we can expect weaker recruitment and business investment. There is a plausible argument that the real issue for business comes later, with the question of whether there will be a “cliff-edge” exit from the EU in 2019 accompanied by the immediate imposition of tariffs.

Rather surprisingly, Chancellor Hammond failed to provide any stimulus despite the improving fiscal backdrop; clearly he wants to keep a war chest if needed in 2018. This does mean that the Bank of England (BoE) will have to keep policy highly supportive both through rates remaining on hold and taking no steps to shrink the balance sheet.

Prime Minister May has called a snap general election on June 8th to get a clear mandate for her Brexit strategy. This introduces a new short-term political dimension to the economic uncertainty in the UK. A clear majority for the Conservative party would strengthen the Prime Minister’s strategy on Brexit and may well reduce some of the feared uncertainty.

 

Eurozone

The economy has improved markedly in recent quarters as the Eurozone has joined the party. This is most evident in the high frequency indicators; manufacturing and service sector confidence has jumped, consumer confidence has improved, the labour market is getting stronger and the consumer has come to life. Improving business sentiment and higher retail sales would suggest that the economy could grow by c.1.5-1.75% over the next year or so. The improvement in the labour market is rather important and may signal a more sustained economic recovery. The unemployment rate is at its lowest since the onset of the financial crisis and wage growth has picked up. Despite this, there is significant slack implying that if the economy can sustain growth, job creation should accelerate. It is still a “may” as to whether the political cycle, discussed later, could yet rear its ugly head.

The European Central Bank (ECB) had already extended Quantitative Easing (QE) through to the end of this year, albeit at a slower monthly pace. Given that the economy is gradually improving and that inflation is also edging higher, there is an argument for the ECB to move away from its very successful monetary stance. There is no doubt that it has been successful as seen by the pick-up in bank lending and consumption and business investment. However, Mario Draghi’s recent comments suggest that there will be no rush in moving away from the current stance. Some of this may be to offset any potential political volatility that lies ahead, the continuing Greek debt discussions and the ongoing Italian restructuring.

The critical European political cycle begins this month with the first round of the French Presidential elections.  The field is terribly fractured and it would seem at this juncture that Le Pen and Macron will go forth into the second round but one of Fillon and the left wing Melanchon could yet spring a surprise and join Le Pen. The polls (for what they are worth) suggest that Le Pen will fail in the second round against any candidate. Clearly a Le Pen victory would require a vast swing from voters; recent history shows that the rise of anti-establishment parties should not be underestimated.

 

Emerging Markets (EM) Outlook

The EM economic outturn has been stronger than most projections, with India and China still leading the pack and Russia and Brazil improving. The most feared Trump policy of trade protectionism has not been put into place (as of yet) and remains a significant risk to globalisation and world trade growth. As with most Trump statements (pre-election) the post-election reality has been somewhat different and it would seem that there has been a significant shift in the stance towards China as well. It had been labelled as the currency manipulator but the President has now rowed back taking pressure off the yuan. Some of this may be a realisation that China’s influence, economically and indirectly through its large Treasury holdings, makes it far too important to rattle. Nevertheless, we will continue to watch out for any shift in rhetoric translating into concrete policy.

China kicked off 2017 in a fairly robust manner, with a number of key features: Stronger investment, higher infrastructure spending, and relatively solid consumption. The annual key meetings in China (the National People’s Congress and the Chinese People’s Political Consultative Conference) reaffirmed the robust growth objective of c.6.5%. Overall, fiscal policy is set to be more supportive than monetary policy. The latter will be marginally tighter in an effort to curb the debt build-up over the past decade. But as always, deleveraging without a recession is rather difficult and great success should not be expected.

India seems to have survived the de-monetisation shock last year fairly well as GDP growth slowed only marginally to just 7%. The outlook is quite rosy looking ahead as government plans bear fruit, monetary policy remains loose, inflation has edged lower and companies have raised investment. The medium-term outlook is for sustained growth of 6.5-7%. The Modi-led Bharatiya Janata Party (BJP) has also secured impressive victories in state elections, most notably in Uttar Pradesh, the most populous state with a landslide win. This bodes well for the general election in a couple of years’ time suggesting that growth supportive polices will remain intact. India also benefits from being out of the line of fire in terms of Trump’s trade protectionism threat.

Brazil is gradually emerging from the recession and may yet end up with GDP rising this year. A lot of this better news is down to the end of the corrosive corruption led political stalemate and the normalisation of inflation. The Central Bank has been extremely active with yet another 100bps shaved off the key rate. The outlook is for further loosening, particularly as fiscal policy is frozen. Other Central Banks may be less willing to cut aggressively but the overall monetary tone should remain supportive.

Returning to protectionism and trade agreements, it is important to re-iterate that the impact of a Trump presidency will not be felt uniformly across the EM. Those economies with high external debt and a high degree of foreign participation in local bond markets are most vulnerable to a rise in debt service costs and capital outflow as US rates rise. Even for countries that have less foreign-currency-denominated debt but which are still reliant on credit growth, a slightly more active Fed and a stronger dollar imply less ability for many EM central banks to provide support through monetary policy.

 

Darker clouds

Despite the many uncertainties (and the binary nature of many of them), financial markets are indicating few signs of nervousness about economic prospects. A number of key risks (policy uncertainty, excessive USD strength, European fragmentation, Chinese debt overhang, and Geopolitical instability) were examined in detail at the start of the year in our Q1 2017 Global Macro and Market Outlook. Needless to say these still remain in play and we will continue to monitor developments.

This section will briefly look at two potential risks that could have a significant influence and change the current positive sentiment: Fed monetary policy/bond market normalisation and Trumponomics stuck in neutral.

 

Fed Policy normalisation

As the global economy recovers, output gaps narrow, inflation normalises, banks get stronger and the consumer recovers the need for ultra-accommodative policy is eroded. As expected, the Fed reached the reversal point earlier than other major Central Banks due to the strength of the economic recovery. The Fed has begun to outline the next phase of policy normalisation in the form of shrinking its significant $4 trillion balance sheet.

Just to remind readers that in the aftermath of the financial crisis not only did the Fed cut rates rapidly, it also entered the bond markets over a number of years to initially stabilise the markets but latterly indirectly to lower bond yields and to dampen bond volatility. This dampening, of course, led to other risk sector volatility also falling allowing for a jump in risk appetite. As argued earlier, the Fed is now at the point of reversing the balance sheet expansion. The easiest way of doing this is to stop reinvesting principal payments (i.e. no longer reinvesting either the Treasury or Mortgage Backed security redemptions). The chart shows in that the case of Treasuries the majority of redemptions will take place from 2018-2023. The 2018 redemption is almost $450 bn.

To some extent the Fed has crowded out other traditional investors within the Treasury market and it may be that these investors could easily step in. However, this process of the Fed retreating from the market at the same time as potential fiscal easing could lead a damaging rise in benchmark bond yields and bond volatility. We are frequently asked how far could bond yield rise. In the case of relaxing purely the QE variable within a bond valuation factor model, the impact is c.100bps. Of course there are many other variables such as fiscal policy, inflation, GDP growth, developments in risk markets, geo-politics and USD reserve currency status that also have an important bearing on bond yields. Our initial target post-Trump victory was for a move to 3% (10-year benchmark). The yield did rise to 2.65% in mid-March from under 1.7%. Since then there has been a counter rally on the back of geo-politics. We believe that a move above 3.5% would require a significant loosening in fiscal policy and a pick-up in inflation. A damaging shift to 4% would require GDP growth and inflation shifting to 3%.

In tandem with the gradual upward trajectory in benchmark bond yields, bond (and therefore equity) volatility should also normalise. Interestingly despite policy uncertainty rising rapidly, asset price volatility has fallen. This sort of divergence is not normally sustained (particularly as the Fed retrenches). Higher US benchmark bond volatility will have an impact on other assets market volatility and valuations.

 

Trumponomics stuck in neutral

The first quarter of President Trump’s time in office has seen a number of false starts, reversals and failures. This may just reflect changing background circumstances and the reality of what the President faces in the real world. Changes in foreign policy have been stark but is not something that we will focus on. What matters to our asset allocation is the lack of follow through on key economic measures. OEF (Oxford Economics) have rather neatly tabulated President Trump’s first 3-months (see chart below). Some of these elements have changed since the table was constructed just at the beginning of April – most notably it would seem that China is no longer seen as a currency manipulator. The whole agenda is extremely fluid despite the Republicans being in control across of three branches of power.

It is clear that the three policies that should have the greatest positive economic impact have either been delayed or are being reconsidered; namely household tax reform, corporate tax reform and infrastructure spending. To some extent the growth projections for 2017 (ours and consensus) included a small positive fiscal impulse but growth projections for 2018 were boosted by between 0.5%-0.75%. Failure to move ahead later this year would lead to growth projections being cut with all of the negative consequences for risk markets.

What we already know with the new President is that nothing can be taken as given. This does lead to complications in assessing the economic outlook and therefore the asset market outlook. We maintain our more cyclical bent on asset allocation for the next quarter but remain cognisant of underlying valuation and other risk parameters.

London & Capital managers of both equities and fixed income will continue to manage beta, duration and credit risk.

 

ASSET MARKETS OVERVIEW

Fixed Income

As observed in the 1st quarters over the previous 3 years, the bearish market undertones failed to materialise, and this time around, there have been good reasons that have held investors back from rushing for the exit door. In particular, President Trump’s reflationary plans aren’t panning out as well as he had hoped, meaning delays in tabling his fiscal expansion programmes to Congress. Nevertheless, global growth momentum is still in play, and if anything it is accelerating. Faster growth is supportive of credit markets and though global monetary policy will remain exceptionally accommodative, a bearish view from our perspective requires a turn in the default cycle (driven by a deterioration in the state of the economy and underlying leverage).

The bond allocation will be overweight financials (particularly subordinated debt), moderate weights in high yield and EM debt offset by underweight high grade investment grade (IG) and sovereign paper.

 

Government bonds - tactical underweight: The key event markets had been awaiting, namely a smooth path to Congress for President Trump’s fiscal expansion plans, were dealt a blow (for now) by his failure to get a new healthcare bill passed. However, we believe the largely unfunded proposed tax cuts will see the light of day, but not as early as we had thought. The ongoing economic growth momentum should limit any substantial rally in Treasuries, with the bellwether 10-year maturity’s yield unlikely to move much below 2.2% (having ended 2016 at 2.45%). The Fed will start to unwind its massive $4.2tr balance sheet (much) in early 2018, which should have the effect to gradually re-pricing the artificially low level of government bond yields.

Outside the US, growth remains steady in the Eurozone although hanging over the markets are up and coming French presidential elections. The topsy-turvy changes in opinion polls may end up with the least favoured outcome for the 2nd voting day on 7 May, namely the extreme left versus the extreme right; neither candidate will be welcomed by the French or the Euro-member markets. The ECB may at some stage later this year address how it plans to taper its own balance sheet. In the UK despite many analysts upgrading 2017 GDP forecasts, the gilt market is likely to focus instead on the post-Brexit effect on lower real disposable income and how that may quell household demand.

 

Financials – strategic overweight: London & Capital strategies have gradually increased the weighting in bank and insurance bonds over the past 5 years and we recommend an overweight in 2017, particularly in subordinated bonds. The focus remains on the Global Systemically Important Financial Institutions (G-SIFI’s), national champions and major insurance companies.

Rationale for overweight: tight regulations have driven a significant improvement in bank balance sheets with higher Common Equity Tier 1 (CET1) ratios, lower risk weighted assets and far greater high quality assets. In essence, banks have deleveraged significantly. This basic drive towards higher regulatory driven capital ratios will remain intact over the next few years. There is likely to be some easing back on certain bank restrictions particularly in the US but in our judgement this should not materially dilute the move towards stronger balance sheets.  The revenue stream for banks should also be in better shape as a direct function of higher rates, a stronger economy and greater lending margins. Insurance companies are also undergoing their own tightening regulatory cycle, a process that aims to strengthen their equity base.

Risks: the election cycle in Europe in particular, de-regulation in the US, potential stock market correction and a spike in sovereign yields are all potential risks, especially for the higher-beta subordinated universe. However, in our judgement these should not be viewed as akin to 2008 or 2010 but rather a source of more normal price volatility; these risks should not be seen as a reason for cutting exposure.

 

Corporate High Yield – selective overweight: Higher yielding corporate bonds began the year in a post-Trump celebratory mood, with revenue hopes latching onto both the current momentum in economic demand, as well as for a rise in order books once the reflationary package takes shape. Despite a relatively rocky performance by energy prices in the 1st quarter, the backdrop appears good for the overall sector, apart for some credits that carry sub single-B ratings where valuations look overstretched. We are recommending overweight in cyclical sectors in the US and Europe.

Rationale for selective overweight: First and foremost, the stronger growth momentum will aid high yield bonds. In addition, generically the high yield sector is still supported by reasonable leverage & interest cover, high cash balances and relatively low refinancing risks. High yield spreads and the technical background are both supportive. Clearly this does not mean that a scatter gun approach can be taken to allocation, as detailed due diligence will need to be carried out.

Risks: A significant correction in stocks and a sharp rise in sovereign bond yields are the two main market related risks. In terms of stocks, a 10-20% correction would be the norm, i.e. not a bear market move but could lead to heightened high yield price volatility, though this is unlikely to lead to a major shakeout or a shift higher in default rates. The key risk to high yield is a recession (which is not our base case), which would trigger a significant jump in implied and observed default rates.

 

EM IG and High Yield debt – selective overweight: London & Capital strategies have benefitted considerably from the selective approach to EM debt with the overweight in India and China. This overweight in sovereign, quasi-sovereign and large-cap corporate bonds will be maintained. Brazilian exposure has been raised and is likely to be raised further. The overall strategy will, however, continue to be selective.

Rationale for selective overweight: Internal growth dynamics in China and India look reasonable and credit dynamics are also very supportive. Faster US growth is generally seen as good news for EM and there is no reason for this relationship to break down. We do not see President Trump’s “Made in America” stance as a major impediment to trade growth. Brazilian authorities are at pains to make 2017 significantly better for the economy than the poor 2016; this in turn should feed through to better conditions across satellite Latin American regions.

Risks: An outright trade/currency war is clearly a risk, particularly for the higher beta EM economies. However, our selective exposure should shield the portfolio.

 

Investment Grade – tactical overall underweight: The overall allocation to IG will be underweight but there will be a skew towards cyclical and sectors in the US that should benefit in the medium-term from higher defence, infra-structure spending (construction and home-builders). European IG exposure will be less skewed towards cyclical names as the ECB and BoE asset purchases support the wider market.

Rationale for selective overweight: The stronger growth momentum, reasonable leverage & interest cover, high cash balances and relatively low refinancing risks are all supportive.

Risks: A sharp rise in sovereign bond yields would overwhelm relative spread compensation and would risk an abrupt end to the economic expansion, in turn threatening corporate prospects.  In Europe acute political uncertainty could undermine IG appeal particularly for lesser-quality credits.

 

Equities

The majority of global indices continued their upwards trend in Q1 2017 towards, or even past, (S&P 500) their 10-year highs with good performance now more broadly spread across sectors. Volatility remained extremely low but interestingly cross-asset correlations have collapsed underlying the increasing role of active asset management going forward.

Economic momentum remains supportive for the equity space. Moderate interest rate hike cycle seems more reflective of positive macroeconomic surprises than core inflation which remains contained as most countries still have not managed to close output gaps (possibly except for the US, where we see some potential for overheating going into 2018).

President Trump’s first months in the office proved benign with medial noise not translating into actual actions. This has both positive and negative consequences for equity markets. First, the lack of significant disruption to global trade (so far) is supportive of cyclical recovery, and thus of Europe and EM. On the flipside, if President Trump is not able to deliver on key initiatives like the infrastructure spending and/or the tax reform, it would harm the very bullish sentiment towards USD and US equities – as already demonstrated by the negative market reaction to the failure to appeal ‘Obamacare’ at the end of March.

Aggressive long market positioning, low cash levels and demanding valuations also need to be mentioned as the largest risks that might temper the equity market’s potential for an extended rally into 2017.

 

US

For most of the first quarter, US equities continued to rally in expectations of the fiscal stimulus promised by President Trump, with relative outperformance of banks (on possible relaxation of the Dodd-Frank Act) and other economically-sensitive sectors (led by infrastructure), as well as the defence space.

‧ This performance reversed in late March when the Republicans failed to attract enough votes in the Congress to repeal the Affordable Care Act (‘Obamacare’). The market has thus been reminded that any other important proposals (including infrastructure spending or tax reform) might also face obstacles to be passed/implemented.

‧ After the strong rally since the Presidential elections, US valuations became stretched and the market’s consolidation appears justified.

We believe the reforms could still go through but the risk that they might be scaled back and/or their results could take longer to filter through the economy (late 2017 or even 2018) seems to have increased.

Absent the reform in the short term, market’s attention should revert back to economic momentum which looks sustainable; consumption doesn’t show signs of slowing while soft business confidence indicators have started turning into hard data improvements. The weaker USD should also become supportive.

Against this backdrop, equity market’s performance will likely depend on the ability of companies to deliver on the not overly demanding earnings growth expectation of 10% for 2017.

 

Europe (excluding the UK)

Continental Europe entered its election cycle with an unexpected twist towards unification (in both the Netherlands and France) which should ultimately lead to a decrease in equity risk premiums.

The continent has also surprised in terms of economic growth. First, exporting sectors, especially energy and materials have been leading the stronger than expected recovery as higher commodity prices, a weak Euro, and the very low base from last year are all helping positive earnings revisions.

The recovery has, however, been broad based with domestic economies also accelerating. They are driven by both healthy consumption (fuelled by improving labour market conditions and real disposable income growth as inflation remains well under control) as well as stronger corporates (as credit is finally flowing into the real sector).

All these factors contributed to increased interest in European equities and relative outperformance versus other developed markets in the first quarter.

The European equity universe is heavily weighted towards international stocks and commodities with a high proportion of earnings derived from the US and thus a potentially weaker USD might be detrimental to the profit trajectory going forward.

Therefore, we will be considering strengthening our presence in the region with addition of domestically focused companies.

 

UK

UK equities posted a modest gain in the first quarter of 2017 but marginally lagged their US and European peers both in local currency and USD terms. However, the UK earnings momentum continues to be solid, seeing one of the strongest earnings per share (EPS) upgrades for 2017 amongst its European peers, underpinning the positive price performance year to date.

The economy has not seen any meaningful negative impact from the decision to leave the EU just yet. However, the uncertainty is just as present as a few months ago, given the precise implications of the government triggering Article 50 are not clear and the market is yet to respond to any new information providing details on what the future might hold for the country.

 

Japan

As Japanese equities benefitted strongly from the Yen’s depreciation in the fourth quarter of 2016, the reversal of the currency weakness led to, of the largest indices, Nikkei, becoming the only one to decline in the first quarter of 2017.

The weakness occurred against the backdrop of roughly 4% lower earnings estimated for the quarter on a year-over-year basis and marginally better economic forecasts.

In the background, core inflation faltering back towards zero might suggest that the cyclical revival seen elsewhere is not really coming through in Japan.

Combined with persistent structural headwinds (demographics and excessive savings ratio) and relatively full valuations we see very little to support the stock market in the short-medium run.

 

Emerging Markets

‧ The first quarter of 2017 was good for EM equities which outperformed all other regions.

The risk of potential trade barriers from the US that rattled the space at the end of 2016 seems to have diminished, and the market has instead welcomed the leading indicators of a strong pick-up in global trade for the first time since the Global Financial Crisis.

‧ The other important driver has been the pace of interest rate hikes by the Federal Reserve which, if it continues to be gradual, should not outweigh the overall positive impact of strong global momentum.

The universe remains extremely diverse, with strong misalignments visible both on country (eg. reform-driven growth of India or China stimulus vs. Russia and Brazil’s return to growth vs. recession in Chile, tighter monetary policy of Mexico vs. looser in Brazil, political overhaul in South Korea), and sector/company level (exporters vs. importers, growth vs. restructuring etc.)

At London & Capital we stress once again the importance to be selective while picking countries and sectors but overall see the current environment as supportive for EM equities.

 

London & Capital Equity Strategy

The maturing equity market cycle is likely to bring more volatility as we progress throughout the year, with the market caught between aggressive positioning and high asset prices on the downside and positive macroeconomic conditions on the upside. Our core portfolio strategies are well positioned to benefit from a further market appreciation and should provide a better shelter against potential turbulences. Tactically, our supplementary satellite strategies strengthen our exposure to faster growth.

We believe we currently have a good combination of safety and sensitivity to cyclical acceleration stocks across portfolios. As Europe moves through the election cycle and being mindful of the increasing uncertainty around Brexit, we are re-evaluating international exposure potentially in favour of domestic names.

 

Hedge Funds

The first quarter of 2017 was a positive one for the hedge fund industry against a relatively benign backdrop for wider risk assets, with benchmarks gaining between 2% and 3%. Alpha generation has improved markedly from 2016, especially among Equity Long/Short managers who were able to take advantage of strong dispersion.

While industry flows still remain under pressure, especially among larger managers who have underperformed for some time, positive performance has helped hedge fund assets reach an all-time peak at a little over 3 trillion (source: HFR). We believe that a lot of activity among market participants is focused around a shuffling of the pack; re-allocating to recent winners and to smaller and medium sized funds. This is a trend we expect to continue in the coming months as investors adjust their portfolios.

Our overall philosophy is unchanged as we continue to believe in a highly selective approach among upper quartile hedge fund managers with a strong, long-term track record of alpha generation.

Moving forward, the broad London & Capital hedge fund selection contains a core of uncorrelated strategies combined with some higher risk/return opportunistic funds for those clients with the requisite risk appetite, which we believe will provide the optimal approach into 2017. We continue to see good opportunities for alpha generation moving forward and London & Capital will look to take advantage of multiple strategies across the asset class:

Equity Long/Short: We continue to focus on sector specific strategies in financials, technology, healthcare and biotech. Continued intra- and inter-market dispersion is creating strong opportunities for those with specialist knowledge that can take advantage of both long and short opportunities.

Equity Market Neutral: Both discretionary and systematic market neutral strategies have exhibited strong alpha and we believe this will continue in a bifurcated market. In addition, the low risk profile of neutral strategies ensures a focus on capital preservation in volatile markets.

Macro/Commodity Trading Advisors (CTA): Macro and CTA strategies will continue to benefit from diverging global macroeconomic policies and dislocating events such as the European elections and geopolitical noise coming from the new US administration. In addition, CTAs have the potential to benefit from any extended periods of risk off sentiment as evidenced by Q3 2015 and Q1 2016 performance and therefore we believe these strategies provide a complimentary hedge to traditional asset classes.

Opportunistic: We continue to favour niche strategies in power, agriculture and volatility trading. We believe the uncorrelated nature of these strategies is attractive in the current environment if sized correctly.

 

Summary

The global cheer has been sustained as the cyclical uplift that started in the middle of 2016 has been sustained into 2017, with even the Eurozone joining the party. The outlook remains positive with a synchronised recovery underway, despite the Fed embarking on a gradual monetary tightening cycle. The major economies are benefiting from an uptick in consumer and corporate confidence and this should be sustained in coming quarters. There are potential clouds ahead including a reversal in the ultra-accommodative monetary policy, Trumponomics getting stuck in neutral and stretched risk market valuations.

We maintain our overall asset allocation strategy we mapped out at the start of the year, with a slight bias towards equities (equally split between the core and satellite strategies), fixed income, a bias towards financial bonds, selective high yield and hard currency EM bonds. Geo-politics is also emerging as an issue leading to a flight to quality and underpins our strategy of not tilting allocation to purely cyclical themes.