Toby Nangle, Head of Multi-Asset EMEA, and Maya Bhandari, Portfolio Manager, Multi-Asset, at Columbia Threadneedle Investments, discuss their latest asset allocation positioning, explain why they have moved to strongly favouring Japan and provide an update on the Threadneedle Dynamic Real Return Fund.
We have upgraded our view of Japanese equities from favour to strongly favour, marking our first such move to an equity market. Asset allocation strategies have been overweight/invested in Japanese equities since the summer of 2013, a period associated with both good performance and cheapening relative valuations on strong earnings delivery.
But five factors have led us to further raise our allocation: increased strength in bottom up corporate earnings; evidence of ongoing corporate reform driving better shareholder returns; firm economic expectations; receding political risk following Abe’s snap election victory; and high operational leverage of Japan Inc to synchronous global economic improvements.
Despite a stellar 20% total year-to-date return (in excess of global equity returns, in dollar terms), Japanese stocks continue to trade at a discount to global stock indices. Abe’s election win and renewed mandate to continue with Abenomics should also see Haruhiko Kuroda continue for a second term as Bank of Japan governor – and this will further support Japanese risk assets in the months to come.
A lot of the positive sentiment we hold right now is focused on the positions that we have: that is to say equities over fixed income, equities over cash, a continued global growth environment, and reflation coming through. Where we have exposure are the places that are most exposed to the above – clearly Japan, but also Europe ex-UK and Asian emerging markets, where there is little real prospect of monetary tightening on the horizon and no fiscal changes in the offing. These are the markets where we are most optimistic as we move into 2018.
In the US the Trump administration appears to be edging closer to introducing tax reform: the question is, how meaningful will any package be? Managed funds have been underweight US equities following a downgrade from neutral to dislike in March this year, but we are mindful that there are positive dynamics at play in North America.
US equities are well-placed to benefit from secular ‘megatrends’ in technology and beyond, such as the shift to cloud computing, artificial intelligence, connected cars, and 5G wireless. The semiconductor industry currently sits at $350 billion and is forecasted to grow by another $100 billion over the next five years due to these trends. In many cases the direct beneficiaries are monopolistic. Also, the current valuation of the US tech sector, on a price-to-book basis, points to a market that is by no means cheap, but not extremely overvalued. Certainly, on a forward price/earnings basis the sector remains cheap relative to its history.
So to tax reform, where we have marginally higher expectations of tax cuts than the market. If corporation tax is cut, many of the companies that are most domestically focused – and which performed best immediately following the election – may lead the market. Our analysis though suggests that there will not be significant market upside from successful tax cutting, somewhat in contrast to our intuition and the consensus. Within US portfolios we have key overweight positions in technology, healthcare (tilted towards biotech), and large financials – and all stand to benefit from loosening regulation. Our underweight positions are in consumer staples, utilities and REITs due to their bond-proxy characteristics, with the largest underweight in retail, reflecting negative sector growth and high competition. Excluding any upside from the potential tax reform, we currently forecast 10% earnings growth for 2017 and 2018 with potential risks to this including another energy slump, increased banking regulation, a materially stronger US dollar or a Federal Reserve policy mistake.
The outlook for fixed income assets seems less constructive, as we move towards the end of the current credit cycle. We have had an unusually long expansionary phase, with equity markets returning a higher positive return than credit markets every year since 2012 (a typical sign of the expansionary period). There is some concern that corporate leverage is at elevated levels, however our work indicates that this is intentional rather than unintentional – even with strong earnings, leverage remains high because it currently makes more sense for corporates to buy back shares than pay back debt. Key measures of creditworthiness such as interest cover are remarkably strong.
Our asset allocation group has a neutral allocation towards investment grade (IG) corporate bonds though our global fixed income team recently took the decision to mark IG credit down to negative. On our part, barring an acceleration of policy rate increases or a decline in global economic health, we have decided to maintain our neutral allocation to corporate IG. While potential upside may be somewhat limited, the red flags typical of an imminent sharp sell-off are not yet present.
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