The growth backdrop remains supportive, although at the margin there appears to be some softening in momentum in the US and UK. This is resulting in the synchronicity of global growth appearing to be less pronounced than was the case earlier this year. What is notable, however, is that this slight slowing in momentum has done little to shift central banks from their willingness to exit emergency levels of stimulus. In their view, deflation risks have been largely defeated and this has been evidenced by the hardening tone of more hawkish iterations in recent weeks, albeit nuanced and modest. In short, the direction of travel is clearly in favour of policy normalisation.
In consequence, we believe that central bank policy risk is rising. Risks may come from less liquidity being added to financial markets as the Fed starts to unwind its balance sheet; the fact that central banks may not necessarily be the backstop they once were should global growth falter; and finally, the potential adverse impact of any further hawkish communications or policy actions on investor sentiment. Given greater interest rate policy uncertainty and recognising that valuation levels in some parts of financial markets are elevated, we believe it is appropriate to begin to reduce equity risk in portfolios, with a view to further reducing exposure in coming weeks. This begins a phased and incremental programme of risk reduction, though flexible enough to be re-calibrated in either direction to adapt to changing economic conditions. We also consider that by starting to reduce risk levels now, we expect to be in a better position to take advantage of market opportunities were we to see higher levels of volatility.
Equities: While our central case of reasonable economic growth, supportive central bank policy and only modest upward pressure on inflation remains intact, we are more concerned about the possible impact of less predictable central bank rhetoric and actions, which may potentially lead to increased volatility across markets. Therefore, we are beginning a modest reduction in equities, although continuing our policy of targeting specific themes. We are viewing the US as a source of funds given valuations, but maintaining exposures in healthcare and smaller companies. We are retaining overweight positions in European and Japanese equities, as economic momentum continues to improve. In Japan, we have increased exposure to smaller companies in our higher risk strategies. UK equity remains an underweight position and we believe it is still too soon to repatriate overseas assets, given domestic political uncertainties. We are maintaining a bias to UK larger companies, which have performed well as sterling has weakened over the last year. We have trimmed some of our EM equity exposure following a strong run this year. We are comfortable at current levels and consider that the longer-term structural case remains intact, given improving growth prospects, expectations of policy easing in several economies as inflation trends ease and ongoing liquidity flows.
Bonds: The hawkish tone of recent central bank communications has caused some re-evaluation across sovereign bond curves, pushing global yields higher especially in the intermediate-dated sector. These moves have been supportive of our long-running stance that the market is too dovish relative to central banks and we may expect further re-pricing in the second half of the year. Credit spreads have remained firm against a solid global backdrop. We believe that a short duration stance remains appropriate.
Property: We retain our underweight position, believing this to be a prudent stance in light of UK political uncertainties, as well as acknowledging the maturity of the current economic cycle. While activity has slowed and there are questions about rent sustainability, our regional bias and reasonable discounts on certain instruments will provide some protection in the event that market yields move higher. At this stage, there is no appetite to add overseas exposure.
Commodities: Factors weighing on the oil price continue to be concerns around the effectiveness of OPEC production cuts to counter rising US production; scepticism that Qatar and Iran will cooperate with Saudi cuts; and Nigeria and Libya ramping up production. Industrial metals have been performing better, especially copper, implying better news on China. We are maintaining our position in gold as we continue to see it as an important diversifier for portfolios.
Hedge funds: While we have held a limited allocation to hedge funds in recent years on concerns around performance, we believe that increasing monetary policy divergence should create more opportunities in this sector going forward. Our preference remains for macro/CTA strategies, but we are also taking a more positive view on equity hedge strategies given the greater likelihood of increased stock dispersion (i.e. between winners and losers).
Cash: We have reasonable levels of liquidity across our portfolios both in cash and short-dated bonds, which we will invest as and when we see specific opportunities. Market volatility remains low – a situation that we believe is unlikely to persist as we move into the second half of the year.