The equity market has started 2018 on a strong footing, picking up where we left off last year. The fundamentals remain strongly supportive – improved global growth accompanied by rising profitability, particularly in Europe, Japan as well as in the emerging complex. Events that might typically be problematic for equity markets, including tightening by the Federal Reserve or political turbulence, are taking second stage to the underlying fundamentals.
We believe the equity market can continue its advance and we are positioned for it to do so. However, we must be cognisant of risks on the horizon, including what central banks may have to do should inflation accelerate. For now, inflation remains quiescent. We saw a small uptick in US core consumer price inflation last week but, for the most part, inflation has yet to show signs of a convincing acceleration in the US, western Europe and Japan, all areas which are at or near full employment.
Moreover, the pick-up in market-based inflation expectations remains modest and is not out of line with long-term measures of stability. But precisely because a more rapid acceleration of inflation is not expected, overheating is the single biggest risk for markets in 2018. More precisely, the risk is the impact higher inflation would have on expectations for monetary policy. In contrast to the gradual ‘normalisation’ already underway, any central bank tightening would become more determined and less predictable. The consequence would be negative for duration fixed income markets, but would also lift the equity risk premium, producing a de-rating of global equity markets. Put differently, the current levels of equity valuations partly reflect a predictable and benign adjustment of monetary policy. Should inflation accelerate, that assumption would be challenged.
The biggest surprise of early 2018 has been dollar weakness, evident against the euro, sterling and the yen, amongst others. Market participants were not prepared for dollar depreciation. Many probably anticipated that the combination of tax cuts and better US growth would boost the dollar.
So why has the dollar weakened? Primarily because equity flows are shifted to Europe, Japan and emerging markets, as those regions are (correctly) perceived to offer more earnings upside, as well as more attractive valuations. In addition, current account balances work against the dollar and, in particular, in favour of the euro. That combination more than offsets interest differentials, leading to a global excess supply of dollars, pushing down its exchange value.
Nevertheless, the dollar is likely only testing the upper bands of a trading range. Versus the euro, the top end of the range is probably around 1.25, with the bottom in the vicinity of 1.15. We doubt we will see a meaningful or lasting breakout from either of those ends of that range during the first half of 2018.
In our portfolios, we continue to favour equities, but have become more selective. Specifically, we prefer mid- and small caps in Japan, emerging equities and domestically oriented firms within Europe. Within the US, where we are closer to neutral, we favour financials and information technology.
The biggest shift is reducing fixed income exposure. We avoid the long end of yield curves (apart from UK gilts) given the depressed level of bond yields relative to fundamentals, the risk of higher inflation and the prospect of more widespread monetary policy adjustment. Most areas of liquid credit are richly priced and unattractive. We are therefore shifting more of our allocation to alternatives, including equity long/short merger arbitrage and target return. We think these strategies complement well our equity holdings and provide portfolio diversification traditionally offered by bonds, but which is less attractive given fundamental mispricing in much of fixed income.