Policy divergence was a key theme for many investors at the start of 2016, amidst a raging debate over the risks of secular stagnation. 
US interest rates had just risen for the first time in almost a decade and the US Federal Reserve expected further hikes over the year. In contrast, central banks in other developed markets were committed to ongoing stimulus.
Yet these policy differentials led to a very strong US dollar which substantially tightened financial conditions, creating a crisis environment that forced the Federal Reserve to adopt a more dovish approach.
Entering 2017, policy divergence is once again an important theme following December’s increase in US interest rates.
Policymakers forecast three more hikes over 2017 and Federal Reserve Chair Janet Yellen has said that it would be “unwise” to wait too long before another rate rise. Meanwhile, the ECB continues to buy government bonds and Japan’s central bank has reiterated its commitment to its more stimulative yield curve targeting policy. The Bank of Japan expects to continue asset purchases until inflation exceeds its two per cent target.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
Despite policy similarities, we are much more positive on the economic outlook for 2017.
Unlike 2016, US rates are rising against a backdrop of unexpectedly strong economic data and improving corporate profitability. This should create a more benign environment in which growth helps offset the impact of a strong US dollar.
There are certainly plenty of indications that economic growth will remain strong.
Economic sentiment is surging following Trump’s election victory, with the NFIB small business optimism survey reporting a record one-month gain in January. Such positive animal spirits are crucial in generating a more sustainable economic expansion.
The US is close to full employment and this should help Trump’s tax stimulus plans to generate higher inflation and stronger domestic growth. We think that the inflation risks will ensure that US government bonds remain under pressure in 2017 and we are avoiding high duration bond funds.
Growth-sensitive US small caps can make further headway and we therefore remain invested in Legg Mason Royce US Small Cap Opportunity.
The environment is also very supportive for Japanese value equities.
The Bank of Japan’s stimulus policies should remain in place even if global inflation picks up as we expect. This would keep shorter-dated bond yields lower than their global counterparts, leading to a weaker yen and a steeper yield curve.
Cyclical exporters and financials are two parts of the equity market dominating Japanese value funds such as Man GLG Japan CoreAlpha and Eastspring Japan Dynamic.
Cyclical exporters are strong beneficiaries of a weaker currency and have already started to report very strong earnings growth. According to Goldman Sachs, sectors such as automotives and chemicals were key contributors to year-on-year net profit growth of 20 per cent for Japanese equities in the most recent quarter, far ahead of expectations of a four per cent growth.
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
Positive earnings surprises were the largest since Japan’s Abenomics revolution over four years ago and we expect further progress in response to improved policy effectiveness. Banks are also demonstrating encouraging signs and should continue to benefit if the yield curve steepens as we expect.
We have continued to build our currency-hedged position in the Man GLG Japan CoreAlpha Fund over the first two months of the year. Although the value style in Japan has outperformed strongly since mid-2016, this followed a prolonged decline and we believe the conditions are in place for significant further strengthening in 2017.
Mark Harris is head of multi-asset at City Financial. The views expressed above are his own and should not be taken as investment advice.