Investment Outlook - By Tom Elliott - 23/05/2017

Near-term market sentiment: Unnecessarily nervous. A week ago market commentators were complaining that the VIX index (of implied volatility on the S&P500) was at a 23-year low of 9.77. Surely, they said, this implied investor complacency? Aside from making the error that the VIX needs to be mean-reverting (it may tend to, but that’s different), those commentators should now be relieved that the VIX currently stands at over 15. No one can still accuse investors of still being complacent. But prepare for the VIX to fall back to low levels: the two triggers behind the rise in the VIX and mid-week falls on global stock markets, being Trump’s links with Russia and (to a lesser extent) corruption allegations made against President Temer of Brazil, do not look substantial enough to trigger a global stock market correction. To put it bluntly, would global capitalism weep if Trump was impeached or resigned from office, and why would investors flee global risk assets if such a thing happened?

Broad economic and political assumptions for rest of this year: World GDP growth continues to accelerate, from 2.9% last year to a forecast of 3.5% in 2017 (IMF estimate), which will feed through into solid corporate earnings growth. Last week Japan reported first quarter GDP growth of 2.2% (annualised rate), making it the longest single stretch of growth for more than a decade. The euro zone grew at 2.0% over the same period. Certainly the U.K grew at a more modest 1.2%, as inflation eats into real wages, and the U.S grew at 0.7%. But while the U.K may be about to enter a period of weaker growth as a result of Brexit, the U.S is now on target to record 2.2% GDP growth this year thanks to much stronger economic activity this spring. China -if the data is to be believed- hums along at just over 6.5% growth. Another two rate hikes from the Fed this year remain likely, but global inflation pressures remain mute and central bank policy looks unlikely to spoil the generally fair environment for equities

In the U.S, we may see Trump getting some corporate and income tax reductions and business de-regulation through Congress this year, but little else relevant to investors.

A large increase in the Conservative Party’s majority in Parliament after the 8th June election should allow the U.K government to negotiate a smooth transitional arrangement for a softer Brexit than previously expected, should it wish to go for that option. However, investors may be confused by Prime Minister Theresa May, whose election policies increasingly resemble a mix of the 2015 election manifestos of the Labour Party and UKIP. Sterling to remain sensitive to Bexit negotiations.

Within the E.U, it is the Italian election (to be held no later than next spring) that appears most likely to deliver the next populist government after those of Hungary and Poland. In France, Macron will struggle to push through reform policies given the lack of a parliamentary majority for his party, but his support for the E.U will help the organisation deal with Brexit, and make progress with a banking union which many see as essential in order to break the link between euro zone bank and sovereign debt crisis. Angela Merkel to remain Chancellor in the autumn German elections.

Dollar to be flat, metal prices remain highly sensitive to China growth data. Oil trades $50-$55 a barrel, with Russia and Saudi Arabia agreeing to push for an extension of current production caps by OPEC and key non-OPEC producers at their next meeting on 25 May.

Taking the above assumptions into account: Remain fully diversified, with perhaps a bias to the Europe ex UK region, funded through an underweight position the U.S. European political risk is likely to continue to fade and growth to accelerate, while in Japan Abe will continue with his ‘third arrow’ of structural reform despite recent personal political setbacks. Dividend yields in the euro zone, the U.K and Japan remain comfortably higher than those of comparable government 10 yr bonds, but in the U.S the S&P500 yield is less than that of the 10yr Treasury - which suggests stretched valuations. The prospect of a softer Brexit, should the post-election U.K government choose to pursue it, is good for sterling and so negative for the FTSE100 index due to its international exposure. Neutral emerging markets: corporates appear vulnerable on account of the burden of dollar-denominated debt taken on over the last decade, and an over-reliance on the Chinese and U.S economies with domestic demand growth having lagged export growth.

If we are to worry about a global stock market correction, perhaps China trumps Trump. There is a risk that, in curbing credit growth too rapidly in order to reduce borrowing, Beijing tightens monetary policy more than the economy can stand and induces a period of much slower growth. A potentially sharp devaluation could be triggered, that in turn leads to fear of imported deflation in the West. Remember July and August of 2015?

If U.S and European wage inflation remains modest, further gains may be had in fixed income but caution is advised. A bias towards short duration and limited exposure to high yield -which appears expensive- perhaps yielding the best results.

The yield on 10 year US treasury bonds fell by 10 bps to 2.24%, which meant that prices went up during the week

Source : Datastream 20.05.2017