Outlook 2018 - Multi asset income: US still matters most for 2018

Outlook 2018 - Multi asset income: US still matters most for 2018

In 2017, markets proved to be calmer than many investors expected. In 2018, US inflation could surprise the market by being higher than expected, and this could provide opportunities in US Treasuries and financial debt. The year could also herald renewed European political risk given Brexit negotiations, Italian elections and Catalonia independence.

What is your investment outlook for multi asset income in 2018?

The biggest surprise this year has been how calm markets have been. Strong global growth and loose monetary policy have been extremely positive for risk assets, with many markets rallying to record highs. If growth remains strong though, central banks will have to begin reducing support.

While that will lead to greater market volatility, risk assets should perform reasonably well if growth remains supportive and we continue to see earnings growth come through.

In terms of relative performance, high quality bonds will certainly face a more difficult environment. A positive backdrop will extend the length of the credit cycle, allowing high yield bonds to deliver carry-like returns.

The outlook for the US dollar is an important question for emerging market assets and commodities. I think the dollar is likely to remain range bound over the next 12 months, with interest rate differentials preventing further depreciation.

Given the broader strengthening of the dollar since 2014 though, I also think we have likely seen the peak. This is positive for income investors in local currency emerging market debt, although they will probably have to tolerate higher currency volatility.

My wildcard for the year would be renewed European political risk. We will start to have a much clearer idea of how Brexit will affect the UK-EU trading relationship. News flow around this, as well as the Italian elections and the Catalonia situation, could harm sentiment around European assets and will have to be something to watch closely.

Chart 1: Global growth strong in 2017

Source: Oxford Economics, OECD, Datastream, November 2017

Chart 2: Positive year for risk assets, despite rate hikes

Source: Datastream, November 2017

What do you think could most surprise investors next year?

I think the path for US interest rates could surprise investors most next year. Assuming a rate rise at the December 2017 Fed meeting, there will be three rate rises in 2017. Markets are pricing in only a 10% chance of a similar number of rate rises in 2018.

US data remains robust, however, with some evidence that inflationary pressures are beginning to build. The New York Fed’s inflation nowcast shows inflation rising, and the weaker dollar should also act to support prices. With US growth remaining robust, it doesn’t seem inconceivable that we have a repeat of the same macro conditions we experienced this year.

While I wouldn’t expect inflation to rise significantly above the Federal Reserve’s target, markets are pricing in very low expectations for inflation and further rate rises. That makes them vulnerable to relatively small surprises. I see opportunities in US financials, which will benefit strongly from rising interest rates. As yields rise, defensive protection like US Treasuries could also become attractive, and this is something I will be monitoring very closely.

How do you plan to capture the best opportunities and add value for investors?

I expect to make more use of a barbell strategy in 2018, adding to lower risk, lower yielding assets like US Treasuries, and higher risk, higher yielding assets like financial debt and equities.

While financial debt, such as CoCos, has performed well in 2017, the asset class has lagged broader bond markets. Financial debt therefore offers a relatively attractive yield, having also withstood tests like the failure of Banco Popular earlier in 2017.

I expect enhanced income strategies to become more important in generating income for investors. These are normal dividend paying equity strategies which also sell buy options on some of their holdings. The premium they earn for this is then paid out to investors as an extra source of income. As well as the extra income, they are a more defensive way to play equity markets over a medium-term time horizon.

On the defensive end of the barbell, I will be looking to add to US investment grade debt as yields rise. As we near the end of the cycle, building in some defensive protection is a sensible approach. We will be buyers of US bonds when 10-year Treasury yields rise above 2.5%, though I expect yields could rise as far as 3%.

EUGENE PHILALITHIS is a Multi Asset Portfolio Manager at Fidelity International. Eugene joined from Russell Investments in 2007, where he was responsible for managing approximately $10 billion in multi manager fixed income mandates. He has 20 years of experience in portfolio management.

Eugene holds an MBA and a Bachelor of Engineering from Imperial College London and is a CAIA charterholder.


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