Beyond the UK election, what matters in H2 2017?

The most prominent themes so far have been low volatility, positive earnings momentum, synchronised strengthening of leading indicators, the comeback of formerly unloved regions and receding political risk.

If 2017 ended today it would be certainly remembered as one of the smoothest investment years of the last decades. Risky assets are up while government bonds are flat or slightly up, therefore most diversified investment portfolios should be in positive territory as of today.

Risk-adjusted returns were extraordinarily positive for investors since the beginning of this year and in the last 12 months. For example, the annualised Sharpe ratio (average return in excess of risk-free rate per unit of volatility) of the MSCI AC World Index was a stunning 3.1 versus a 1.3 over a five year average.

There is good and bad news for investors. The good news is that the world economy is currently doing well and that corporate earnings are growing and the risk of recession remains low despite the mature age of the current expansion cycle. The bad news is that asset valuations are no longer cheap.

The price-to-earnings ratio of global equities are above their long term average and the risk premium or spreads of corporate bonds are below their long term average. This has two consequences for investors. Return assumptions on equity and spread investments should be moderated and secondly the time of cheap undifferentiated beta investment has come to an end.

Although average market valuations are not cheap anymore, there are still pockets in the market where the risk premium to be earned remains compelling. Equities in emerging markets and Europe are still attractively valued and should perform well if the positive growth environment persists.

Looking at fixed income, emerging market local currency bonds are one of the few segments where the current yield of 7.2% is above the 10 year average.  Also, high yield despite relatively low spreads should still benefit from the positive earnings trend.

Investors shouldn’t become complacent because of the low volatility period we are currently experiencing. History teaches us that phases of low volatility don’t usually persist very long. Weaker growth in China because of monetary tightening and a disappointing growth recovery in the US are risks for the market going forward.

If recent polls are right that Eurosceptic parties currently have a majority in the upcoming election in Italy, it could pose a major political risk event. On the back of very moderate return expectations going forward, it is not time for heroic bets in the portfolio. Diversification with a slight tilt to equity risk is still preferable in this environment. Flexible and market neutral investment strategies should get more consideration.

 

Tilmann Galler is global market strategist at JP Morgan Asset Management

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