According to Russell's analysts, there are five main themes that are shaping and will shape the market in the coming period.
1. TRUMP EFFECT
Expectations on Trump's policies have shifted investor sentiment towards a risk-on approach. Stock markets have risen and bond yields have increased. US stock valuations are stretched, the market is overbought and the sell-off in bonds has been excessive. For this reason, a market slowdown should present a possible opportunity to add risk exposure to portfolios.
Economic data, both in the US and globally, have improved recently, leading to some optimism in the equity market. The US, however, faces some challenges including high profit margins, rising labor costs and the possibility that the Fed will hike rates at least twice during 2017. As the economy improves, forecasts on US corporate profit growth are becoming more optimistic, but risk creating disappointment if cost pressures erode margins. Investors could get a boost from Trump's proposals on corporate tax cuts and fiscal stimulus.
However, Trump may have some difficulty pursuing his rhetoric, given that tax cuts have to be funded somehow. Furthermore, there is the threat of a trade dispute with China, which would alarm the markets.
2. DIVERGENT BOND MARKETS
Diverging trends are always a strong theme in bond markets. The Bank of Japan has vowed to keep government bond yields near zero, Brexit-related uncertainty stalls the Bank of England, while the ECB continues its quantitative easing program.
A majority of our sentiment indicators suggest that the US Treasury market is oversold following the sharp rise in yields. This means that there is a chance that yields could pull back if disappointing growth news emerges or if Trump's protectionist actions lead to a risk-off phase for markets.
However, the US economy is running out of spare capacity and inflationary pressures are slowly strengthening. Our estimated fair value for the US 2,5-year yield is between 3 and XNUMX%. The medium-term trend for long-term sovereign bond yields is up.
3. EMERGING MARKETS: A BALANCED VIEW DESPITE ATTRACTIVE EVALUATIONS
Emerging markets got off to a bright start to 2017 thanks to statements by the Trump administration on excessive dollar strength and thanks to the positive surprise in economic data from major emerging economies. We maintain a balanced view despite attractive valuations.
There are positive bottom-up indicators from improving earnings and trade. China has made notable progress towards stabilizing its economy (despite continued pressure from capital outflows). However, from a top down perspective there are also downsides that pose a potential threat to deleveraging with Fed tightening.
A renewed dollar recovery could lead to a potential liquidity crisis for emerging markets. There is also a risk that the Trump administration implements an aggressive protectionist agenda. Here, our approach – as with other asset classes – encourages us to be patient until a decline from current levels creates an opportunity to increase exposure in the portfolio.
4. DEFENSIVE STRATEGIES
During 2016, we marginally increased the defensive stance in our portfolios. The defensive segment is mainly composed of credit, the asset class to which we have the greatest exposure. This preference reflects our desire to participate in risk rallies through credit exposure and through an additional layer of optionality embedded in convertible bonds, while retaining the relative protection of a bond-based allocation.
Additionally, protection against potential equity market downturns has been maintained through the use of derivative strategies which provide us with downside protection.
5. THE RUN IN BOND OVER THE LAST 30 YEARS WILL NOT REPEAT
The yields offered during the 30-year bond run should be less noticeable in the near future. Yields have moved into negative territory and even if rates are to rise from here on out, it is unlikely that positive returns will be generated by duration exposure alone. This is not a reversal from the last XNUMX years, it's just unlikely that the same situation will repeat itself.
Dynamic management of income allocation will play an ever increasing role. We expect to see a decline in diversification benefits historically based on government bond exposure alone. Therefore, the way we define diversification will broaden to include a range of strategies, broad sector positioning and innovative investment techniques.
