A broadening recovery in markets supports risk taking, according to Aberdeen Standard Investments’ Andrew Milligan, although investors should be aware of the potential for policy errors in the current climate.
The head of global strategy said differences between central bank “rhetoric” and the underlying economic data has prompted debate over the medium-term outlook for bond markets.
Milligan said: “In recent weeks, more central bankers have stated that they see the conditions falling into place for a withdrawal of some of the monetary support they have provided to the global economy.
“The European Central Bank, the US Federal Reserve, the Bank of Canada, the Bank of England and People’s Bank of China could all move to tighten policy during 2018, either through higher rates or by tapering QE programmes.”
In response, said Milligan, yields have backed up – “quite sharply in places such as Germany” – while core inflation pressures seem to be contained in the short-to-medium term.
He said: “Cyclical forces include excess Chinese industrial capacity and continued slack in the European labour market – although there is always uncertainty around these supply-side assumptions.”
On the structural front, he said changes in labour market wage negotiations; the impact of automation, globalisation and technology on pricing power, and enhanced price discovery have all been flagged as potential drags on inflation.
“Consequently, we expect core inflation to remain restrained in coming months,” he explained. “This means the Fed and the ECB should act in measured ways when they withdraw policy. Otherwise, our concern would be that a major policy error is appearing.”
As such, Milligan said in the fixed income space valuations remain an issue and that while he does not consider duration to be “a dangerous position to hold in portfolios”, he considers the benefits are likely to be limited.
“The only market which we favour is emerging market debt, where spreads look to provide adequate compensation for investment risk, even if growth in China is constrained,” he said.
In equities markets, Milligan said the firm remains bullish about regions that stand to benefit from increased confidence.
“Into 2018, we expect global equity markets to benefit from more confidence about a continued expansion, sustaining buoyant corporate cashflow,” the global strategist said.
“There is potential for fiscal policy to provide an additional boost to the short-term cycle.
“Much will depend on the US and the ability of the Trump administration to push through a stimulus, which would likely largely consist of income and corporate tax cuts, before the mid-term elections in autumn 2018.
“Our favoured equity markets are the US and Europe, and to a lesser extent various emerging markets, while we are neutral elsewhere.”
Over one year, the MSCI Emerging Markets index has risen by 21.05 per cent – rebased into sterling – while the US and Europe indices have also performed strongly, as the below chart shows.
Performance of indices over 1yr
Source: FE Analytics
More recently, slowly accelerating global growth and better corporate profits have benefitted global equities.
“The combination of better top-line sales and strict cost control for most companies has benefited corporate earnings,” he said.
“Profits growth for the S&P 500 Index in Q1 2017 – using this as a global proxy – was up about 14 per cent from a year earlier.
“Expectations for the second quarter earnings season suggest 5-10 per cent growth.”
Beyond regional preferences, Milligan said investors should consider a number of drivers to monitor for individual sector.
“These include the relative steepness of the yield curve, which will feed into expectations around net interest margins in the financial sector; the impact of the moderate slowdown in the Chinese economy on commodities; the ongoing disruption from online shopping on the traditional retail sector; and the anticipated slow expansion of capital spending as businesses put cash to work,” he said.
“Indeed, sector analysis is becoming more useful in order to understand wider market movements.
“For example, a key feature of the US stock market in the second quarter was the underperformance of the technology sector, as we saw profit taking and a rotation into other cyclical and financial stocks. This underperformance then snapped back as earnings reports revived confidence.”
Despite conditions favouring pro-risk behaviour, Milligan said the firm was not planning to introduce any risk to its portfolios.
The global strategy head said that there remain a variety of political risks that could trigger or exacerbate cross-border flows.
The recent stand-off between US president Donald Trump and North Korea over its ambitious missile programme and the subsequent spike in volatility highlighted the impact political events can have on markets.
However, Milligan said investors have taken political risks in their stride in recent months and that tail risks are less worrying even if they cause short-term market volatility.
“A concern remains that political challenges constrain the ability for many governments to make growth-friendly policy changes,” he said. “However, this matters more for longer-term growth and asset returns than the potential for near-term cyclical upswings.”