With a market rotation unlikely to occur during the remainder of the year, GAM Investments’ Larry Hatheway said the firm is retaining its focus on quality against an investment backdrop of bifurcated markets.
After strong synchronised growth in 2017, this year has seen the US pull away from other developed markets while emerging market performance has been hampered by the stronger dollar.
Hatheway said: “The most remarkable feature of market performance in the first eight months of the year has been bifurcation.
“US equity market performance has easily outpaced the global peer group, with select information technology stocks leading the way.”
As the below chart shows, the S&P 500 has returned 12.82 per cent year-to-date – in sterling terms – while the MSCI AC World index has risen by just 5.86 per cent.
Performance of indices YTD
Source: FE Analytics
“In part, we believe US equity outperformance can be explained by the positive impact on cash earnings from last year’s tax cuts,” said Hatheway.
“Equally, a solid rebound of US economic activity around mid-year – in contrast to soggier numbers in Europe or emerging economies – seems to have bolstered the case for US equities.”
GAM’s Hatheway said underpinning much of the performance of the US market has been “a clear investor preference for reliability” translating into companies and countries where cash flows and growth are more predictable.
“Whereas in 2017 markets were characterised by momentum, value and expanding multiples, 2018 seems to have seen a return to global quality as the favoured attribute for investors,” he explained.
The more guarded approach to markets has largely followed the return of volatility after relatively benign conditions last year, noted Hatheway.
However, another factor in more defensive positioning in 2018 has been the poor performance of higher growth but riskier emerging markets.
Emerging markets, the GAM chief economist noted, have been hit by the arrival of a stronger dollar and fears of global trade conflict as US president Donald Trump sought to renegotiate deals and impose tariffs on countries such as China.
“After their strong performance in 2017, many investors came into 2018 overweight emerging markets and thus were caught off guard by their sharp reversal,” the multi-asset strategist said.
“Similarly, concerns about escalating trade conflict, political uncertainty in Italy and sluggish growth undermined the case for European equities, another early 2018 favourite.”
Indeed, the MSCI Emerging Markets index has fallen by 7.69 per cent this year while the MSCI Europe ex UK index remains flat with a return of 0.31 per cent.
Performance of indices YTD
Source: FE Analytics
The GAM chief economist said the question investors have struggled with is whether the bifurcation witnessed this year will continue through to the end of the year.
However, he said it was unlikely that rotation into other markets and fresh leadership is likely to drive performance for the remainder of the year as the backdrop remains supportive of global quality.
“We believe rotation to non-US equity markets will require a more supportive global backdrop for growth and earnings,” he said.
“That, in turn, should demand a combination of a stable – or weaker – US dollar, the absence of contagion from the most at-risk emerging economies to emerging markets as a whole, as well as a more tangible acceleration of non-US growth.
“At present, however, none of these preconditions are sufficiently in place to change investor sentiment.”
Yet, Hatheway warned that markets could falter if protectionism becomes more pronounced, US inflation accelerates prompting more aggressive rate tightening, or if global growth slows unexpectedly.
“If inflation were to pick up significantly and unexpectedly in the US, western Europe or Japan it would change the expectations for monetary policy and drive up interest rates and risk premiums, resulting in market setbacks and weaker growth,” he said.
Additionally, escalating trade frictions could undermine corporate optimism and dampen capital expenditure and unemployment, said the strategist.
Indeed, a potential trade war remains one of fund managers' most-pressing concerns, topping the closely-watched Bank of America Merrill Lynch Global Fund Manager Survey's biggest ‘tail risk’ for the past four months.
Hatheway added: “We believe each of those risks is non-negligible, with the concern that a tightening of financial conditions in emerging markets – given rising risk premiums – might spill over and undermine developed market earnings and growth.”
Yet, with little to suggest that market leadership is about to change, the strategist said the firm is making no changes to its investment stance.
“Overall, we believe the investment landscape does not appear ripe for rotation,” he said. “If anything, concerns are mounting.”
As such, he said it feels “premature” to position for a recovery of the ‘value’ trade, whether in global equities or emerging debt and currency markets.
“In our view, the catalysts for such a reversal are not sufficiently present,” the GAM chief economist explained, adding that it retains a preference for “predictability in various dimensions”.
“Within equity portfolios we remain overweight global quality as a style, accompanied by selective exposure to information technology, with more limited exposure to emerging markets, Europe and Japan,” said Hatheway.
Performance of indices YTD
Source: FE Analytics
As the chart above shows, during 2018 the MSCI World Quality index has delivered a 11.45 per cent total return compared with a gain of 3.21 per cent for the MSCI World Value index.
Hatheway said it retains a preference for shorter-duration fixed income strategies – such as US mortgage-backed securities, insurance-linked debt and US Treasuries – against a backdrop of rate hiking led by the Federal Reserve.
Elsewhere, the firm has maintained its positions in non-directional strategies, such as target return and long/short earnings momentum and merger-arbitrage strategies.