Asset markets are running on a high and investors risk appetites are growing, it seems like the shadow of the GFC has finally faded and the boom is back on. With interest rates still near generational lows, subdued inflation, and improving business conditions, it’s easy to see why investors are getting excited. But if the easy money has been made, where will the returns come from next? We asked three leading economists where they think is the best place to invest over the next 12 months. Responses by Tim Toohey from Ellerston Capital, Sam Ferraro from Evidente, and Nick Bishop from Aberdeen Standard Investments.
Long-only funds to struggle in this environment
Tim Toohey, Economist, Ellerston Capital
The next 12 months should be an important transition point through the industrial cycle. In the major developed nations, we will move through the inflection point where the gains from further economic expansion start to accumulate to labour rather than capital. That is, the ‘sweet spot’ where improving sales growth generates sharp improvements in profit as underutilised resources are reactivated will progressively pass. New capacity additions will still be profit enhancing in the next stage of the cycle, but the expansion comes only via capex and competing for scarcer resources.
Equities can still rise in this environment, but it’s more likely that fixed interest markets have underestimated the risk that above potential economic growth presents in increasing fully employed economies. Combined with ‘quantitative tightening’ by the major central banks and pro-cyclical fiscal policy, the risk of a sufficiently large rise in bond yields to prompt a correction in equity markets cannot be dismissed. This may well still take several more months to play out, but the best strategy is to be short excessively expensive bond markets, wary of bond proxies in equity markets and watchful of the implications for the bubble-like conditions prevalent in corporate credit markets. The preferred expression is to be invested in an investment strategy that can benefit as the world makes this transition.
Unfortunately, traditional long only equity and bond funds will find this transition very difficult, and hence we like the prospects for discretionary global macro funds through the inflection point and into the next phase of the industrial cycle.
Strong US consumer to support equities, but real estate is vulnerable
Sam Ferraro, Director, Evidente
The outlook for asset classes over the next twelve months hinges on the psychology of the US consumer. A continued rise in the durable goods share from current levels would be associated with a further decline in the implied equity risk premium and outperformance from equities. Growth in China’s exports of durable goods to the United States would also benefit.
Key risks relate to the conduct of US monetary policy and Chinese domestic demand. Core inflation in the US has consistently undershot the Federal Reserve’s 2% target since the financial crisis, notwithstanding the low unemployment rate. Further hikes in the federal funds rate would be premature and further undermine the credibility of the central bank’s inflation target. A key driver of domestic demand in China has been renewed strength in construction activity. But many construction and real estate firms have been lifting their gearing levels at the same time as profitability has been deteriorating, making them vulnerable to an unexpected income shock.
Our biggest convictions in fixed income
Nick Bishop, Head of Australian Fixed Income, Aberdeen Standard Investments
We have two main macro convictions. First, overweight AUD front end yields for carry and roll; second, US treasuries should outperform German bunds. Australian household cashflow is impacted by weak wages, higher energy bills and mortgage standard tightening. In the US, tax reform will be drawn out, while Germany is powering ahead, and the ECB is reducing its bond buying.
For non-government bonds, our preference is for Infrastructure, Industrials, Utilities and REITs. Yield spreads are fair value and there is room for further contraction. However, Telecommunications, Autos and Information Technology have narrow yield spreads with limited room for contraction. For some time, we have been cautious in Retail (Woolworths and Wesfarmers), given the Aldi and Amazon effect. Given headwinds for the Australian banks, we prefer the larger, global banks with favourable yield spreads. Given significant housing market exposure, with some weaker underwriting in recent years, we do worry about impacts from a significant housing market price correction.
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