The most recent bouts of volatility arose from concerns about the direction of Italian politics and policy, as well as from renewed concerns that trade spats might create adverse spill overs for global growth. Yet, consistent with the pattern of recent months, fears only produced short-lived setbacks before markets stabilised and recovered.
The recurrence of volatility and the advent of choppy markets has been a feature of markets this year since early February. It is also a pattern we highlighted as our base scenario for 2018 at the beginning of the year. Peaking global economic activity and slowing year-on-year corporate earnings growth, alongside lofty valuations and fresh policy risk rooted in populism, are factors that have underpinned our cautious approach to investing in the first half of 2018.
Compounding matters has been dollar strength, which has undermined returns in both emerging local currency debt and equity markets. Jitters about rising interest rates have also reduced demand for corporate debt, resulting in some credit spread widening. We have also reduced exposure to credit fixed income on concerns about potential illiquidity should market conditions deteriorate more significantly.
Indeed, despite tepid equity performance this year, fixed income allocations have tended to underperform in multiasset portfolios. Unfortunately, many non-directional strategies and other alternative investments have failed to pick up the slack.
Against this fundamental and market backdrop, the asset allocation committee continues to emphasise capital preservation via a cautious stance, achieved with modest equity allocations, short duration fixed income holdings, select non-directional strategies and augmented by the implementation of low correlation strategies. In addition, across various strategies the members of the committee have adopted a more tactical approach to range-bound markets, adding to risk on setbacks and trimming positions on rallies.
Consistent with the aim of capital preservation, in most strategies we have reduced holdings of high-beta European and emerging equities. Within the equity asset class, we maintain a preference for quality. We also focus on earnings-driven returns, with a corresponding preference for Japanese equities and smaller capitalisation stocks, as well as for earnings momentum strategies (including long/short).
We remain reluctant to re-enter duration fixed income, as we continue to believe that monetary policy tightening, global growth and some upward drift in inflation will keep pushing global bond yields higher. Our preference remains for nonagency, short duration mortgage-backed securities. Nor are we averse to holding US short-dated Treasuries, given their enhanced yield. In some strategies we are considering adding precious metals or implied volatility as instruments to improve portfolio risk-adjusted returns.
Given our cautious stance, we also ask what would have to change to alter our view. Among the factors cited would be a recovery from the Q1 ‘soft patch’ of global growth, with an emphasis on where disappointments were greatest, namely Europe and emerging markets. We will pay close attention to that possibility, given that global monetary and financial conditions remain accommodative and supportive of growth. A re-acceleration of European and emerging growth could provide an important source of earnings support to their equity markets, given greater cyclical operating leverage outside of the US.
We are also following the fortunes of the US dollar and oil prices closely. Modest dollar weakness would support emerging debt and equity markets in particular. Flat-to-lower oil prices would also be a plus for risk assets, insofar as they would boost global consumer purchasing power and would also alleviate cost pressures in more energy-intensive industries and regions, including industrials and non-energy emerging markets.