While politics will continue as the key driver of uncertainty in 2017, leading to the potential for policy errors, markets will struggle to discount effectively.
This should create anomalies and therefore opportunities that active managers can exploit, both in stock selection and asset allocation. But this difficulty to price assets could significantly increase portfolio risk as markets react to every news point.
Investors will have to be nimble and hold their nerve in 2017, because it’s not going to be an easy year. My motto is ‘Keep calm, be smart and hold your conviction.’ We will be taking advantage of the uncertainty next year to add quality to our strategy, when others are fearful.
Higher ‘bad’ inflation in the UK
The chances of higher inflation in the UK next year have risen significantly. This is a shift from thinking about deflationary forces. While runaway inflation is not our base case, we think that inflation will rise steadily in 2017.
Sterling has fallen 10% against a basket of currencies since the Referendum. And with negotiations over Brexit due to begin in the second quarter, the pound may well plumb greater depths (although we believe sterling is very undervalued on a long-term view).
This short-term currency weakness feeds through as cost-push (or ‘bad’) inflation, where the prices of raw materials and labour rise. Given that we’re bumping up against full employment and the Bank of England seems unwilling to raise rates, there’s a risk of inflation breaking higher.
We could even see stagflation if growth stalls and prices balloon further. We are therefore focusing on equities with substantial operations outside the UK and non-sterling revenue streams. These include holdings such as Unilever, Ulta Salons and Coca-Cola.
The UK companies we do own are those that we believe have the ability to push through price increases, such as ITV and BT, which have customer contracts linked to CPI. We’re steering clear of cyclical businesses, especially retailers, and are avoiding lower-quality corporate credit and index-linked gilts (counter-intuitively, they would perform poorly because they are even more sensitive to changes in yields than conventional gilts).
Temper tan-Trumps
We’re hedging our bets in the US. For all the furore of Donald Trump’s election to the White House and chatter about the potential for a dramatic loosening of the government purse strings, we think the new administration will be relatively restrained.
President-elect Trump will need the support of the Republican-led Congress to implement his policies, and they’re a fiscally hawkish bunch. Massive unfunded tax cuts and a splurge of infrastructure is not exactly their favoured playbook. Instead, we think Mr Trump will focus on deregulation while settling for moderate tax reductions and some token infrastructure projects – that should benefit US domestic companies.
The theory is that tax cuts will boost household spending and free up cash for corporations to invest more or return capital to shareholders. Meanwhile, any spending on creaking US infrastructure should help businesses such as train and rolling stock manufacturer Wabtec. There’s a risk, however, that Mr Trump’s impetuousness gets the better of him and he follows through on threats to slap tariffs on the US’s largest trading partners and shut down free trade agreements.
It’s easy to imagine a President Trump shooting from the hip on foreign and trade policy, where he can act unilaterally. This protectionism could seriously damage global trade and lower growth both in the US and abroad, perhaps to the point of recession. If that were to occur, we’d cut our exposure to risk assets – equities and lower-quality bonds – the world over. Meanwhile, the US remains one of our favoured equity markets.
European political shenanigans…
It’s been a deep, dark decade for Europe. Almost 10 years after the credit crunch, the Continent continues to strain under the weight of massive public and private loans, anaemic demand and unemployment levels that threaten the social fabric of some countries.
In the second half of 2016, eurozone economic data have been improving, but the cause of Europe’s economic infection has not been treated. Massive debt write-offs are required to clear the banks’ books and revive lending. And substantial labour reform is needed to get the unemployed, particularly the young, into work and improve consumption and domestic demand.
For that, Europe needs strong leaders who can make tough decisions, that cross powerful vested interests. Instead, politicians pandering to the masses with unfeasible or downright damaging policies are gaining ground.
here are several national elections coming up in 2017, the most important being regional heavyweights Germany and France. While investors can take heart from the result in Austria, the resignation of the Italian Prime Minister is less helpful, and the outcome of these contests could have wide-ranging implications for the Continent, the monetary union and global trade.
The remaining members of the EU need to equalise tax rates and become more federal if nationalistic feelings are to be tempered, yet this prospect looks further away than ever. Until then Europe risks echoes of Japan. Because of this, we continue to underweight the eurozone and avoid the peripheral nations entirely.
We hold strong companies whose businesses are somewhat sheltered from the single market, including Finnish financial giant Sampo Group and solid Danish lender Danske Bank. We also own pharmaceutical businesses Roche and Novartis, where the majority of revenues are from overseas. Added to that, we have hedged our euro exposure back to sterling, in anticipation of euro weakness.
Divergent monetary policy
Here we are again… For the better part of a decade following the Lehman Brothers collapse, central banks have rowed the same currents. Now, the US is likely to be the only major economy to increase its interest rate, while all others are loosening their policies or will keep them at ‘emergency’ levels.
This divergence in monetary policy began in 2016 and will continue into 2017. We expect US rates to creep upwards next year, albeit in smooth and steady fashion. The Federal Reserve is likely to have its eye on the health of US economic data and inflation (its designated yardstick). As ever, communication will be all, as this undefined timetable could create much volatility in equity, bond and currency markets.
Meanwhile, it’s very unlikely that we will see higher interest rates in Europe for the next three years. As the US raises rates, the multi-decade bull market in bonds now looks all but over. We remain underweight gilts for this reason.
The few corporate issues we do own mature in roughly half the time of the benchmark 10-year gilt. We own the M&G Global Macro Bond Fund because it has proven itself as a solid performer over time. It has the ability to take negative duration positions, and act as a diversifier if equities and bonds were to fall together. We feel this greater diversity in monetary policy should create more opportunities for an experienced manager like Jim Leaviss to exploit.
Finding returns amid scarce growth
Despite what President-elect Trump says, US growth is unlikely to double to 4% next year, and global growth looks similarly sluggish. Equity markets seem to disagree with us as the year closes: cyclicals are flying, while high-quality growth companies have sold off. This is a short-term phenomenon, in our view. If growth does not jump ahead soon, the share prices of these highly cyclical businesses are likely to slump as rapidly as they are now rising.
We will continue to focus on companies with strong brands, high cash flow yields and low debt, particularly as those businesses have become cheaper since Mr Trump’s victory. Companies that can rely on steady streams of cash have options in difficult times, and those that can raise prices without losing market share tend to be better protected against inflation.
We hold companies that we believe have both attributes, including Alphabet, Visa and Nike. We find most quality global companies are based in the US, which is why we continue to have a bias to North America.
‘Generation Z’
Granted that ‘disruption’ is a tired buzzword, but it remains the dominant theme of our age – even Bank of England Governor Mark Carney has been talking about robots taking 15 million jobs. It’s easy to be blasé about the umpteenth food delivery app start-up; however, there’s no denying the rate of technological development over the past 20 years has been breathtaking.
We’ve gone from prohibitively expensive primitive mobile phones to a compact personal computer in every pocket; from dial-up internet to cable-less 5G. Such changes have driven tectonic shifts in how we make, distribute, and buy and sell retail products. Automation and the use of robotics have revolutionised factory floors in ways that were simply science fiction only decades ago. These phenomena will continue to define the future.
As working age populations in the Western world – and much of the developing world – begin to shrink over the coming decades, technology will have to be part of the solution if we are to retain standards of living. Broad strides are being made right now in driverless cars, artificial intelligence and the ‘internet of things’, which connects our appliances to the World Wide Web.
To the more seasoned individual like me, these changes are monumental, but the younger cohort of consumers, born around the turn of the millennium – ‘Generation Z’ – has known no different. They have lived this cutting edge since birth. As this generation matures, they will drive the need for completely new products, services and means of distribution.
One example of this is the rapid growth of the computer gaming industry. To play this tech super-trend, we invest in Amazon.com, and the Allianz Technology Trust. This trust is based in San Francisco, close to Silicon Valley, where many of tomorrow’s disruptors are based. While the trust isn’t immune to the dangers of high-risk tech investments, we believe there are plenty of exciting investments in its portfolio.
We’ve also designed and bought a bespoke structured product that gives us exposure to a basket stocks in the computer gaming space. These include Activision Blizzard, Nvidia, Electronic Arts and Tencent, among others. Video gaming is no longer consigned to teenage boys’ bedrooms, but is now a widely held pastime for all. It is also big business: in 2015, gaming made $91.8bn; Hollywood films made just $38bn.
However, there’s a risk that these companies at the bleeding edge of tomorrow will find their products – or even themselves – obsolete as developments move apace. Even diversifying as we have done does not negate the possibility of losses in this space.
Searching for diversifiers
Financial assets of all stripes have been more highly correlated than usual over the past year. That is, apart from hedge funds and alternative actively managed strategies, but only because they offered dismal returns.
Many investors searched for diversification in commercial property during 2016, but we think the risks continue to far outweigh the benefits at this juncture. Gold soared in the first half of 2016 before quickly giving up much of its gains in the final quarter. It remains at an elevated level and we don’t really feel comfortable owning it while rates are rising.
Other commodities are more interesting, however. We are investigating buying a bespoke basket of materials, including iron, copper, oil and wheat, as a way of inflation-hedging the portfolio and offering greater diversification into the bargain. We continue to hold commodity trading adviser funds (CTAs) Aspect Capital and Schroder GAIA BlueTrend. These are extremely volatile quantitative trading strategies, but they have very low correlations to equities.
And that’s the point: diversifiers should be chosen on correlation, not volatility. That can mean having to employ nerves of steel, but it usually means better portfolio performance overall. Of course, with diversifiers, it’s important to know their bones, and why and how they meet the objectives of the overall portfolio.
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