Concerns over how long the current market cycle has left to run has prompted Bank of America Merrill Lynch (BofA ML) to shift its European equities position into the UK.
Investment strategists James Barty, Ronan Carr and Jack Iacovou said many investors have begun to worry about whether they should adjust asset allocations and risk profiles to reflect the fact we appear to be much closer to the end of the bull market than the start.
“The concern about the duration of the cycle is driven primarily by the length of the US economic expansion,” the strategists said.
“Now moving into its 10th year, the US recovery is the second longest since the Second World War, only exceeded by the late 1990s expansion, as can be seen from the chart below.
“So it is easy to understand fears that a downturn may be around the corner.”
US economic expansion is the second longest since the Second World War
Source: BofA ML
However, the BofA ML strategists noted that it was one of the shallowest recoveries on record, indicating that there was also some spare capacity in the US economy compared with this point in previous cycles.
Indeed, data from the Organisation for Economic Cooperation & Development suggested that the US output gap had only just begun to close and is now at similar levels to 2003 or 1998, rather than previous cycle-ends in late 2000 and 2007.
“If we look at the picture this way, then the cycle may well have a few more years to run,” said the BofA ML asset allocators.
“Of course, recessions are notoriously hard to forecast and frequently catch economists and investors by surprise, which we suspect is behind the current cautiousness.”
Yet, the BofA ML strategists claimed there was little from indicators to suggest that cautiousness was warranted, with higher inflation and, therefore, a more aggressive central bank policy stance conspicuous by their absence.
“The key point from our perspective is that real rates are not even into positive territory to any degree until well into 2019, which would mean a recession is unlikely before 2020,” they added.
“Given equity markets tend to peak six months before a US recession, this would suggest it would not happen until mid-2019 at the earliest or, more likely, well into 2020.”
If the cycle does have further to run, as the strategists believe, investors should maintain exposure to equities, noting the strong returns to be made during the last two years of an equity bull market.
“We remain fundamentally constructive on the global growth outlook and expect global earnings to increase by double digits this year,” they noted. “Against that backdrop, we expect positive returns for equities.
“However, the slowdown in macro data points to a less outright risk-on environment and we think the intra-market rotation that implies should favour the UK.”
According to the strategists, equities have historically delivered positive returns during the ‘slowdown’ phase of the cycle, favouring stocks with less cyclicality, higher quality, lower beta and risk.
“The UK ranks highly in Europe on such characteristics, has less cyclical sector composition and a lower beta,” they said.
Source: BofA ML
“A potential late-cycle combination of further commodity strength and a rotation into higher quality and lower risk overall would benefit the FTSE 100 with its above-average weight in defensives, energy and materials and underweight in cyclicals.”
Another positive development is the strengthening dollar and weaker sterling, with FTSE 100 stocks generating around 70 per cent of their sales from outside of the domestic market and more than half from outside Europe.
As such, sensitivity of FTSE 100 stocks to weakness in the UK economy is contained relative to global developments, according to the analysts.
“The FX effect is well established,” they explained. “Historically relative outperformance of the FTSE versus other developed market equities was closely related to depreciation in cable [the sterling/US dollar pair rate].”
Further dollar gains, the BofA ML asset allocators noted, should underpin additional earnings momentum and outperformance for FTSE 100 stocks.
The UK market’s high dividend yield relative to other global indices is also a major lure for the strategists.
“The 2018 dividend yield at 4.2 per cent is 60 basis points above the European average and 160 basis points above global equities,” they said. “Moreover, the dividend yield premium versus global peers is also high relative to history.
“The relative dividend yield between MSCI UK and MSCI AC World index is just off its highest level since 2000.”
Additionally, the UK is also attractive from a sentiment and valuation perspective, given its status as one of the most unloved major markets among international investors.
BofA ML’s monthly fund manager survey has revealed that the UK has been the most underweighted trade since the EU referendum in June 2016, falling to historic lows.
Source: BofA ML
“The UK market has been a chronic laggard in recent years,” the allocators said. “In fact, the UK relative to MSCI World is close to the 1976 lows in US dollar terms.”
Money has flowed out of UK equity strategies at an unprecedented rate more recently, with data from the Investment Association highlighting outflows of £4.9bn in 2016 and £2.6bn in 2017. During the first quarter of 2018 there were further outflows of £1.5bn from UK equity funds.
However, there have been signs of some softening of sentiment more recently as a transition agreement has been struck between the EU and UK. In addition, the UK economy, while weak, has continued to grow. The latest BofA ML Global Fund Manager Survey revealed that the UK underweight position had improved in April, although it remains the most shunned region.
During the first four months of the year, the FTSE 100 index was down by 2.32 per cent, compared with a 0.96 per cent loss from the S&P 500 and a 0.68 per cent fall in the MSCI AC World index, in local currency terms, although performance has improved in May.