Russell Investments: look at the top five themes shaping markets

The Trump Effect
The expectation of Trump-policies has rotated investor sentiment into a risk-on posture. Equity markets have rallied and bond yields have risen. US equity valuations are stretched, the market is overbought and the bond market sell-off has been overdone. Therefore a market pull-back should present a viable opportunity to add risk exposure to portfolios.
Economic data, both in the US and globally, has improved recently, and this is adding to equity market optimism. The challenges in the US, however, are high profit margins, rising labour costs and a Fed poised to lift rates at least twice this year. Consensus forecasts for US corporate profit growth this year are becoming more optimistic as the economy improves. These expectations are at risk of disappointment if cost pressures eat into profit margins. Investors could get a boost from Trump policy proposals involving corporate tax cuts and fiscal stimulus.
However, President Trump may have difficulty following through on his rhetoric given that tax cuts have to be funded from elsewhere. Plus, there is threat of an aggressive trade dispute with China, which would put markets on edge.

Divergence in bond markets
Divergence is still a big theme for bond markets. The Bank of Japan has promised to keep the yield on JGBs close to zero, Brexit uncertainty is keeping the Bank of England on hold and the European Central Bank is continuing with its program of quantitative easing.
Most of our sentiment indicators tell us that the US Treasury market is oversold after the big rise in yields. This means that there is a chance that yields could decline if there is disappointing news on growth, or if protectionist actions by President Trump trigger a risk-off phase for markets.
However, the US economy is running out of spare capacity and inflation pressures are slowly building. Our fair-value estimate for the 10-year Treasury yield is a 2.5-3.0% range. The medium-term trend for long-term government bond yields is upwards.

Emerging markets: a balanced view despite attractive valuations
Emerging markets had a bright start to 2017 as the Trump administration talked down the US dollar, and as economic data surprised on the upside in the major EM economies. We maintain a balanced view, despite attractive valuations.
There are positive bottom-up indicators coming through with improvements in earnings and trade. China has been making notable gains toward stabilizing its economy (albeit with continuing pressure from capital outflows). However, there are also negatives from a top-down perspective, representing a potential threat of deleveraging as Fed tightening gets underway.
A renewed run-up in the dollar could lead to EM facing a potential liquidity crisis. There is the risk of the Trump administration pursing an aggressive protectionist agenda. Our approach – as with many asset classes – is to maintain patience until a pullback from current levels creates an opportunity to build exposure to the portfolio.

A marginal increase in level of defensiveness proved favourable while steering through macro events in 2016
Over the course of 2016, we marginally increased the level of defensiveness the in the fund. The defensive segment is comprised primarily of credit, which represents our largest broad asset class by exposure. This preference reflects our desire to participate in risk rallies, through our exposure to credit and through the additional layer of optionality embedded in our convertibles while maintaining the relative protection of a bond-based allocation.
In addition, protection against a potential equity market drawdown was maintained through derivative strategies which provide us with protection should markets fall.

30-year bond bull run unlikely to be repeated
The returns which have been available throughout the 30-year bond bull run are expected to be less apparent going forward. Yields have ventured into negative territory, and as rates are expected to rise from here on out, it is unlikely that positive returns will be generated purely from maintaining exposure to duration alone. This is not a reversal of the last 30 years, it’s just unlikely that we see the last 30 years being repeated.
Dynamism in managing fixed income allocations will play an increasing role. We expect to see a decline in the degree of diversification benefits historically derived from relying solely on government bond exposures. Therefore, how we define diversification will broaden to include an array of strategies, extended sector positioning and innovative investment techniques.

David Vickers – senior portfolio manager – Russell Investments