Our caution towards the equity market has been growing quarter by quarter. This bull market has travelled a long way and largely delivered what we expected: US market leadership, outperformance by developed markets and growth driven more by higher multiples than underlying earnings improvements.
As such, the upside potential for shares is dwindling. The US market may rise from today's 2,500 for the S&P 500 index to, say, 2,700. It is hard to see what would take it further. If there is little volatility, you might think that is worth holding on for. But if markets become more unstable, you are likely to think the reward is not high enough for the risk of short-term loss.
The counter argument is that being out of the market in its final stages has in the past been a painful experience. Shares are supported by relative valuation arguments (where else can you put your money?) so the current levels could easily be sustained for a while yet. As discussed in the focus section, a sideways market in which individual shares and sectors do well cannot be discounted.
The big question is how, after a 30-year tail-wind of falling interest rates, the equity market handles the reversal of monetary easing. The Federal Reserve may be cautious about raising interest rates but it has clearly indicated that it is minded to unwind its $4.5trn balance sheet. Preparing the market for this has prevented a re-run of the 2013 'taper tantrum' but who knows what will happen when the Fed actually stops re-investing the proceeds of maturing bonds.
So, in summary, today’s low-growth, low-inflation environment, with a cautious Fed and reasonable economic growth, might charitably be viewed as a Goldilocks set-up for equity markets. But the main drivers of market appreciation seem to be largely played out. This is the time to be thinking about capital preservation and protection against downside risk.
Select 50 pick: At this stage of the cycle, any equity exposure should be cautious and well diversified. I am, therefore, sticking with last quarter’s pick, Nick Mustoe’s portfolio of attractively-valued companies with strong balance sheets and good management, the Invesco Perpetual Global Equity Income Fund.
The bond market continues to be driven by the investment theme that has dominated the post-crisis world: the search for yield. As the chart shows, investors have been forced further up the risk spectrum in their bid to capture an acceptable income. The gap between the yield on safe government bonds and that on riskier corporate debts is called the spread. Here you can see that this has been narrowing progressively over the past two years as investors have accepted a smaller and smaller reward for the risk they are taking.
This reduction in yield goes hand in hand with a rise in bond prices (the two move in the opposite direction) so bond investors have been happy. After 30 years of falling interest rates, many have called the end of the bond bull market but they have been consistently too early.
In fixed-income investing, the greater the risk of default, the higher the yield on offer. This means that the high-yield segment of the bond market has been its hot spot. As a consequence, valuations are now quite rich. Investment grade corporate bonds, where a slightly lower income reflects a lower default rate, look better value but, here too, valuations are pretty much priced for perfection.
The key driver of the whole bond universe is central bank monetary policy, principally the actions of the Federal Reserve. Here a dilemma is playing out: raise rates to peg back inflation or look through rising prices to a persistently sluggish environment? While interest rates look likely to stay lower for longer, central banks are beginning to reverse the great quantitative easing stimulus that has underpinned markets for many years now.
Central banks have arguably held back from tightening policy for fear of boosting the value of their currencies. A generalised move towards tighter policy removes this pressure and suggests that we will see a progressive squeeze across the developed world over the next few years. If economic growth persists, that will only increase the impetus towards higher yields.
Investors accepting progressively less reward for credit risk
Source: Thomson Reuters Datastream, 28.9.17
Past performance is not a reliable indicator of future returns.
Bonds have a place in a diversified portfolio. But the attraction is definitely portfolio balance, income and capital preservation rather than further capital growth.
Select 50 Pick: With potential rewards reducing, it is more important than ever that a fund can move to the most attractive parts of the bond universe. A flexible fund like Ian Spreadbury's Fidelity Strategic Bond Fund is well-placed to do this.
Important information: Please be aware that the price of bonds is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between corporate issuers.
Expectations for total returns in both the UK and Eurozone commercial property markets have risen since the spring. In Europe this reflects growing confidence in the political and economic backdrop, positive GDP growth and benign monetary policy. In Britain the attraction is mainly currency-related, with a cheap pound making trophy properties look attractive.
Brexit remains a cloud over the UK real estate market. That said, the income outlook is reasonable, with few tenants in distress. If anything, the absence of certainty is encouraging them to secure their current accommodation rather than make plans for taking on new space.
Previous cycles in the UK market have been characterised by debt-fuelled construction booms but there is no oversupply this time. This provides some protection against Brexit-related uncertainty. Industrial and logistics is the sweet spot, with low vacancy rates as the internet shopping boom demands more and larger warehouses.
There is a similar theme in Europe, where anecdotal evidence suggests strong demand for new space and little capacity in the construction industry to meet it. Investors, particularly from overseas, are queuing up to invest in the Eurozone core. This is leading to unsustainable pricing in some cases.
In offices, too, rental yields in the hottest markets are starting to look irrational. They are well below the previous lows in the 2004-8 cycle. For value, you need to look further afield to places like Birmingham, Liverpool and Edinburgh.
Prime yields are starting to look irrational
Source: Fidelity International CBRE Research, August 2017
Past performance is not a reliable indicator of future returns.
Commercial property retains its attractions. It offers a reliable income and is backed by real, tangible assets. But it has never been more important to take an active approach, focusing on income not capital growth and with a risk-averse view of the market’s frothier areas.
Select 50 pick: : The illiquid nature of the property market can make it difficult to move in and out of a real estate investment. For that reason the Select 50 suggests a property equity fund, the iShares Global Property Securities Equity Tracker Fund. Invested in listed stocks, it is correlated to the equity market but provides access to property’s income.
Important information: Some funds in the property sector invest in property and land. These can be difficult to sell so you may not be able to cash in this investment when you want to. There may be long delays in acting on your instructions to sell your investment. The value of property is generally a matter of a valuer's opinion rather than fact.
The oil price has enjoyed a strong summer, regaining all the ground it lost in the first half of 2017. The slide in the price to under $30 a barrel at the beginning of 2016 now looks like a blip and a period of sideways trading around the $50 a barrel mark looks probable.
The stability of crude is testament to the ongoing ability of OPEC to co-ordinate production among its members. Since the beginning of the year, output has fallen by around 1.5m barrels a day, offsetting the excess production from the North American Shale fields. A decision will be taken later in the year as to whether OPEC needs to prolong cuts beyond the first quarter of 2018. Almost certainly it will because Shale production is profitable at today’s price so the taps will remain open.
A stable oil price at these levels is good news. Not too high to crimp economic activity, not so low that oil companies are forced to mothball production and so create a shortage further down the track. It keeps inflation and so interest rates steady.
The other key commodity that investors watch is driven by very different forces. Gold is essentially a hedge against uncertainty and its price bounces around according to how worried people are. The ratcheting up of tensions on the Korean peninsula has seen a resurgence of interest in the yellow metal but really it is just fluctuating in a wide range and well below the peak reached during the Eurozone sovereign crisis.
Select 50 pick: With no income for investors, gold is best seen as an insurance policy against things going badly in the world. If you think a rise is likely from here, the best way to play gold is via an equity fund like the Investec Global Gold Fund.