Psigma Investment Management has been de-risking its portfolios following the strong run of recent years but says it could become outright cautious for the first time since the global financial crisis if exuberance continues to grow. 
In its outlook for 2018, the wealth management firm noted that the past two years have been “a great time to be an investor” thanks to accelerating economic growth, continued ultra-loose monetary policy across the globe and high returns from most asset markets.
Furthermore, investors would have benefitted from a classic contrarian opportunity to buy if they were “brave enough and patient enough” during the sell-off at the start of 2016 then hold them throughout the subsequent recovery.
Last year was another strong one for investors, with almost every financial index making positive returns and many achieving new record highs. However, the wealth manager warned that investors could have become accustomed to making good returns and, a decade after the financial crisis, might have forgotten what it is like to lose money.
Performance of indices in 2016 and 2017
Source: FE Analytics
Tom Becket, chief investment officer at Psigma Investment Management, said: “Our expectation is that 2018 will be somewhat similar to 2017 from an economic perspective, although growth will moderate through the year back to a similar level that we have experienced since the financial crisis of 2008.
“Risks undoubtedly exist, despite the bullish chants of the optimistic chorus. A return of inflation, interest rate rises and a slowdown in China are the pre-eminent risks we are evaluating as we head into next year. We expect our portfolios to make low positive returns next year, but any gains are likely to be driven by specific and selective investment opportunities.
“Investors must recognise that returns in the future are unlikely to match either those healthy gains of the last few years or long run history, despite the fact that the global economy appears to be currently enjoying a moment in the sun. If we see further gains from today’s lofty levels, we might have to assume that asset markets are doing their own impression of Icarus and our ‘balanced, with a hint of caution’ investment stance could become outright ‘cautious’ for the first time since 2008.”
Becket added that investors should now be wondering if the past 12 months – which witnessed a “potent cocktail” of central banks buying of assets, an abundance of cheap money from low interest rates, improving investor confidence, a synchronised global economic expansion and historically low levels of volatility – have been as good as it gets and if more challenging conditions lay ahead.
In giving his outlook for the coming year, the chief investment officer said he is expecting the trend of “solid but unspectacular growth” to continue over the near terms. However, he is worried by a combination of stretched valuations across a variety of assets and what central bankers might make in 2018 and beyond.
A big question is whether the healthy economic growth of 2017 – which improved in all parts of the world in a synchronised manner – can continue. Becket argued that the above trend growth currently witnessed in the US, China and Europe is unlikely to be maintained throughout 2018 and global growth will moderate from today’s 3.5 per cent towards 3 per cent.
The main reason for this expected fall in global growth is a reduced expectation in China’s economic expansion, based on the view that authorities might be willing “tap the brakes more firmly than they have in recent times”. While Psigma is not expecting a collapse in Chinese growth, it thinks a slowdown could be seen in early 2018.
Added to this is the view that the cyclical resurgence in Europe might start to stumble this year, although it will still remain in positive territory; its real test will come when the European Central Bank halts its asset purchase programme. “It is probably only then that we will know for sure whether the strength in the regional economy is ‘real’ or has been fabricated through the greatest monetary stimulus that the world has ever seen,” Becket said.
EU28, euro area and United States GDP growth rates – % change over the previous quarter
Source: Eurostat
However, the chief investment officer added that this moderating global growth could be proven wrong if governments around the world implement fiscal stimulus to encourage growth through lower taxes and infrastructure spending, most notably in the US.
“If the baton of the economic relay race is handed over from monetary to progressive fiscal policy then growth could surprise on the upside to our forecast,” he said. “If you add in the possibility that fiscal policy and tax reforms could encourage companies around the world to invest in economic and efficient expansions of their operations, something which has been vitally absent for the last nine years, then the economy could do much better than our moderate forecast.”
Economic growth aside, the focus of markets this year is likely to stay on the actions of central banks and the key question will be how many times the Federal Reserve lifts interest rates. Psigma is expecting three rate hikes in 2018, which it does not expect to destabilise markets – although it is difficult to know exactly how they will react when it realises the days of extremely loose monetary policy are over.
Linked to this, the firm said its greatest worry for 2018 is that inflation becomes stronger throughout the world as the wage stagnation that has dominated since the financial crisis starts to ease. “Certainly any upside surprise in inflation rates could be a headache for central bankers, who might be forced to raise interest rates more quickly than is currently forecast by financial markets,” Becket said.
“Until perhaps recently, financial markets haven’t detected that there are any inflationary pressures building, so if we were to get a combination of continued price pressures from the Far East as well as long overdue developed world wage price gains next year, then the bond market could suffer worse than our central expectation.”
While remaining mindful of the risks present and expecting equity markets to struggle to make progress this year, Becket said 2018 could be “a fruitful environment” for active managers if they can exploit any uptick in volatility and tap into country-, sector- and company-specific opportunities.
Psigma continues to see value in Asian and Japanese equities, although it has taken some profit from these areas after their strong returns in 2017. In China and related regional markets, the firm is focusing on themes such as the consumerisation of Asia, pollution control and supply-side reform.
It has also been positive on Japan for more than six years and says the country remains an important element of its long-term investment strategy. Despite Japanese equities rising on the back of a stable political situation, good economic growth and continued support from the Bank of Japan, Psigma sees the country as being relatively cheap and has maintained its overweight stance.
When it comes to bonds, Becket argued that fixed interest markets around the world have become “increasingly barren” and said investors now have to think outside of the box to identify opportunities that are attractive from a risk/reward perspective. To this end, the group has allocations to areas such as US mortgage-backed securities, European asset-backed securities and some corporate credit instruments, particularly in the UK where there is a Brexit premium.
Summing up his view, Becket said: “The investment environment of the last two years has been remarkable. The swing from abject pessimism to rampant optimism has been utterly extraordinary.
“Our portfolios have reflected the major change in sentiment and, more importantly, the expansion of valuations, and have progressively shifted from a stance where we were very comfortable taking risk to one where we are much more selective and increasingly focussed upon investments where valuations are genuinely appropriate and compensate our clients for the risks they are taking.
“Our investment strategies have undoubtedly been de-risked, at a time when others appear to be taking higher levels of risk. This in part reflects our contrarian investment philosophy. The sum of our strategies’ parts is not an extremely cautious positioning, but rather a ‘balanced’ and diversified approach with a ‘hint of caution’.”