Investment market update: the return of Goldilocks – where market growth is neither too hot nor too cold?
Although the US Federal Reserve surprised no one by raising interest rates in mid-June and outlining how they will scale back the mammoth pile of assets they own (around US$4.5tn at the last count), markets have increasingly gained solace from the return of Goldilocks to the investment lexicon.
As a reminder, Goldilocks is where growth is neither too hot nor too cold. Her presence means interest rates can stay lower than normal for still longer, even if the trajectory is very slightly upwards. The fact that Donald Trump’s aggressive reflationary agenda is stalled in Congress is actually good news. We don’t want him to heat up the porridge too much.
Meanwhile, fears that inflation may raise its ugly head have abated – in part because the oil price has fallen back to around US$45 per barrel, other industrial commodities have been weak and also because, despite low unemployment, wages aren’t growing very fast either in the US, the UK or in Europe.
This is a good environment for riskier assets over time, since company earnings can grow and interest repayments stay low. However, right now valuations are rather high and so far in 2017, we’re enjoying a good vintage of returns. In the US, the equity market is up 10%, including income, and in Europe returns are almost as good. True, the small recovery in the pound against the US dollar and the euro has eroded these gains a little for sterling-based investors, but here the FTSE All Share is still more than 7% up on the year-to-date. Not bad, given Brexit and the outcome of the UK general election.
At the end of 2016, most commentators, including us, would have said Gilts were overvalued; and yet they too have produced positive returns, with the FTSE Actuaries Gilts All Stocks index up by 2.4%, while in corporate bonds the returns have been closer to 4.4%.
All this leaves us wondering where we go to from here. Complacency seems quite high, at least as measured by extremely low volatility. Valuations in equities feel on the high side to us, with the one year forward price/earnings ratio on the FTSE All Share standing at around 15.3x (in the US it’s 18.2x). The 10-year Gilt yields less than 1.1% (and with UK inflation at around 2.9%, that’s a negative real (inflation-adjusted) return of nearly 2%; spending power here is paying the price of last year’s devaluation of sterling, which is now feeding through to increased import costs.
It feels like we ought to see some form of correction from here, but the actual catalyst to trigger one is difficult to identify, especially since we’ve already ridden through a number of them this year with little impact on the market.
So, what are we doing for our client portfolios?
We continue to hold a little cash in reserve, so we can add to equities if they do pull back, while maintaining a good weighting to shares. We continue with our emphasis away from the UK – where Brexit means uncertainty – and in favour of the US and increasingly, Europe. We struggle to own much exposure to Gilts, with returns so low, although corporate bonds feel like somewhat better value. This should be a good environment for alternative assets, such as infrastructure, absolute return funds and multi-asset funds that seek to generate steady returns above cash, but with less volatility than equities; we remain supporters of assets in this area.
Even if there is a pull back in equity markets over the summer, we don’t think the medium-term picture is too bad. Economic growth is robust, at least outside the UK. Company profits are growing, dividends are increasing, and even if they are rising gently, interest rates are still very low by historical standards. Goldilocks is with us and supping the porridge, but we don’t expect the three bears to turn up for a while yet.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.