We are currently in a “Goldilocks” scenario in terms of growth, inflation and interest rate expectations, according to Henderson’s Paul O’Connor (pictured). 
However, he urges investors to keep a close eye on US wage growth and capital expenditure for warning signs of the economy overheating and tipping the balance.
Yet, the head of multi-asset says there is nothing definitive on the horizon to derail the current investing environment and believes the current inflation trade could well have further to run.
“The big reflation trade came along before [Donald] Trump, it started at the end of June, then Trump supercharged it in the autumn. In some of these instruments such as the Russell index or the banks - the more cyclical parts of the market - there has been a very big reflation trade,” he explained.
“If you looked at those charts alone, you would say ‘wow, everyone is very confident about the state of growth’. But, if you look elsewhere in the market, you would wonder whether there’s been any kind of reflation trade at all.”
As such, O’Connor believes we are only part of the way through the eight-year ‘hunt for yield’ which has been sparked by the strong performance of bonds, the increased popularity of so-called ‘bond proxies’ pushing up equity valuations and rock-bottom interest rates.
Performance of indices over 8yrs
Source: FE Analytics
While many industry commentators are expecting fiscal loosening to end this trend and cause an asset class rotation from bonds into equities - and from lower-risk equities into cyclicals - the manager says the hunt for yield remains intact.
“If you look at fund flows this year, more money has gone into bonds than has gone into equities. That is a very striking statistic,” he reasoned.
“Even though some areas of the equity market are quite hot, investors are buying more bonds. If you look at the credit market it seems euphoric, spreads keep getting lower every day, yields keep going lower every day, these assets have been completely untouched by inflation.
“I would say the big picture is that investors have embraced the reflation trade, and it shows that they have priced in a cyclical upswing in macro momentum, but what they haven’t priced in is a big change in the structural picture.”
O’Connor says the performance of bond markets suggests inflation expectations are increasing, but negative real yields indicate that interest rates could stay low for a considerable amount of time.
“We’re in this funny world where we have two big themes; one is that there’s faith in a recovery and in inflation and that’s lifted some parts of the market quite exuberantly, but at the same time we also have a big faith that rates will stay lower for longer and central banks will remain accommodative for a long time, and the hunt for yield will remain intact,” he continued.
“I would depict this as a bit of a Goldilocks scenario. Growth is not too hot or too cold, it’s just right. You have enough recovery to sustain a move in the reflation trades, but it’s not so hot as to really undermine credit markets.
“It could go on for quite a long time. In a sense, everyone is edgy in these markets, everyone is wary and waiting for something to go wrong. We worry about Trump, we worry about Brexit, we worry about France, we worry about China. But it could be that this Goldilocks scenario stays in place for quite some time.
However, O’Connor says the potential ‘too hot’ scenario that could tip the balance is a rapid boost to growth in the US economy. While strong growth in regions such as Japan or Europe can be controlled by accommodative monetary policy, he warns this is unlikely to happen in the US.
He also says that excess growth is more plausible in the US than other regions, given president Trumps’ proposed policies for fiscal loosening.
“A positive growth surprise could also have a big impact on rates in the US,” the manager continued. “Let’s imagine growth is too strong. I think the key thing to watch would be wages.
“If wages were to surprise to the upside in the US it would force the Fed’s hand a bit more and I think that could be a bit tricky for markets.
“So far we have had very good pay roll surprises. Growth has been quite good and job growth has been really good but wages haven’t picked up. If they pick up too much, that would be a game-changer and could end this Goldilocks environment.”
O’Connor argues that we are yet to see a fully-fledged asset class rotation from bonds into equities but, if US wages were to increase, it could be a catalyst.
In terms of equities, he says it would lead to a rotation away from bond proxies and into cyclical sectors such as commodities.
That said, he doesn’t believe the environment will necessarily be conducive for ‘risk on’ investors, but would make cyclical equities more appealing in a relative sense compared to fixed income.
“If the Fed was forced to become more turgid, I think it would raise some real questions for credit,” the manager warned.
“Credit markets have just become bigger, and bigger, and bigger. We’ve never seen them this big. There are more and more retail investors in them.
“Their liquidity hasn’t really been tested and we just don’t know would happen if we saw a sudden change in attitude in the hunt for yield.
“I think that would be a challenging environment for markets. It’s a plausible story, I think so far the data has been nice and benign. Fairly strong growth, not much inflation but, if you’re worried about this type of scenario, the thing you have to watch is wages in the US and capex picking up.”
In contrast, O’Connor says the ‘too cold’ scenario – growth failing – is less worrying for investors. He explains that, if US growth cools off, Trump is more likely to implement fiscal loosening.
“I don’t think growth cooling down in the US is that bearish, it might cause a few problems in some reflationary areas but I think it could have a positive impact elsewhere in markets,” he said.
“I don’t think it’s a game-changer for risk. The one area where I can see where a negative growth surprise could be a big deal is China.”
Equity markets started 2016 on a markedly bearish note, with some major indices trading on hefty losses by the middle of February.
Performance of indices January – 11 February 2016
Source: FE Analytics
This was mostly due to fears surrounding China, as plummeting commodity prices caused the Shanghai Composite index to freefall from historic heights reached just months before.
Markets quickly recovered as a result of Chinese monetary policy and went on to deliver a choppy, sideways performance in 2016. However, O’Connor warns a prolonged growth scare in China could have much more significant ramifications for investors.
“If I could imagine a scenario in which we really do lose faith in growth and begin to worry about the ‘too cold’ growth scenario in China, that would undermine the inflation trades, it would undermine commodities and it would undermine emerging markets,” he noted.
“It would give us a flavour of what we had in Q1 last year. I think it’s less of a worry to be honest, the first scenario worries me more.
“The central case is: we’re constructive on growth. We think it’s quite plausible that this period for growth is just okay, that it continues with just about enough growth to keep reflation trades intact and continues.
“But, the scenario we worry about the most is the US overheating and we just have to keep a close eye on this.”
Since O’Connor joined Henderson from Mercer in 2013, the Henderson Diversified Growth fund – which he manages alongside Chris Paine – has returned 19.38 per cent compared to its LIBOR GBP 3 Month benchmark’s return of 2.17 per cent.
It has done so with a maximum drawdown, which measures the most money lost if bought and sold at the worst possible times, of 5.84 per cent and an annualised volatility of 4.3 per cent.
Performance of fund vs benchmark under O’Connor
Source: FE Analytics
The £226m fund has a clean ongoing charges figure of 1.84 per cent.