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Will the positive trend in markets continue for the rest of 2017?

Nathan Sweeney, senior investment manager, Architas looks at whether volatility will hit the strong and stable run for markets that we’ve seen so far this year

The first half of 2017 has proved a remarkably benign period for markets. For all the concerns about elections, both planned and impromptu, the ‘Trump bump’ becoming a ‘Trump slump’, and broader geopolitical concerns distracting markets, this uncertainty did not result in poor performance or increased volatility. In fact quite the opposite has happened as returns have been positive while markets relaxed into a period of calm with market volatility at multi-year lows.

We have seen positive market returns on all the main asset classes with a very stable environment from a macroeconomic perspective. With synchronised global growth boosting ‘risk-on’ asset classes like equities while surprisingly subdued inflation has meant fixed income investments have also delivered steady returns.

But are we going to see this positive trend continue for the rest of 2017?

We see three main risks to the continued growth. First, the actions of the US Federal Reserve and other central banks around the globe. The US economy seems to have transitioned out of its post-financial crisis malaise, with unemployment reaching target levels and inflation beginning to rise. The Fed has been confident enough in the recovery to move rates higher with three rate rises since December. The Fed has also signalled its intent to start reducing the size of its balance sheet. After years of endless monetary expansion how the Fed, and other central banks, begin to roll back their QE policies will have a significant impact on markets.

Second, although China has been largely absent from the headlines this year compared to start of 2016 it still continues to present an underlying risk. The government appears to be managing the country’s economic transition relatively well, maintaining high levels of growth. However, we always maintain a healthy degree of scepticism, especially when things appear overly positive. Concerns in China include the use of leverage, a strategy of using borrowed money to grow assets or even an economy. This is not a sustainable model so we do question how long this can go on for.

Finally, we have some concern about the degree of market consensus. In this situation with too many investors in the same assets a market scare motivating a mass sell off could cause a real liquidity crisis. While we don’t see any immediate catalyst for this type of market correction, we do see a high degree of consensus among investors, implying a certain degree of complacency.

Having looked at the risks there are also three areas where we see potential for returns. We have recently decided to move to a moderate overweight position in emerging market equities, particularly in the Asian region. We believe that stocks are offering good value in comparison to those in developed markets. The region has enjoyed strong economic momentum recently. Companies in developing countries within the region are likely to benefit more than their developed Asian counterparts from rising global growth prospects.

We also believe the environment is right for European equities to continue performing well in the second half of the year, particularly in light of easing political risks. Earnings growth in Europe is forecast to outperform the US. This should support rising stock prices in the region, and as a result we are maintaining an overweight position in European equities.

Finally, we have been increasing cash slightly across most of our portfolios where appropriate, from low levels at the beginning of this year. This increase in cash is in keeping with our cautious stance around the UK election, Brexit, market complacency and other risks.

These higher cash levels will also give some flexibility to take advantage of any market corrections. Although not guaranteed it would not be a surprise for the rest of 2017 to finally see increased levels of volatility after such a strong and stable run in markets.

 

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