Fund Commentary - Allianz Global Sustainability

What Happened in January

Global equities started the year strongly, fuelled by growing demand for risk assets. Emerging market equities rallied the most, boosted by a weak US dollar (USD) and optimism over the strength of the global economy. Despite a government shutdown, US stocks followed closely enjoying their strongest start to the year since 1987¹, spurred on by strong company earnings and a tax cut tailwind. Companies in the financial, industrial and resources sector tended to beat expectations, while technology companies continued their strong run.

At a sector level, consumer discretionary stocks led the charge, significantly outperforming the wider market. Information technology stocks also continued to perform well, despite social media companies sustaining renewed criticism for their role in shaping public opinion². Defensive and higher yielding sectors, such as consumer staples, real estate, telecoms and utilities retreated, undermined by rising bond yields.

The global economy continued to show signs of robust health, with Europe’s purchasing manager index (PMI) hitting a record high of 60.6. This has fuelled speculation that central banks will become more hawkish. 10-year US Treasury bond yields rose above 2.7 per cent, a level last seen in 2014, while 10-year German Bund yields approached 0.7 per cent. As the first few days of February have shown, this has increased volatility, as well as the potential for market corrections.

The month also saw China release its gross domestic product (GDP) figures. These showed that the economy grew 6.9 per cent in 2017, a 0.2 per cent rise from last year, and the first increase in seven years. This has been attributed to stronger exports, renewed infrastructure spending and credit growth.

Commodity prices rose, with gold gaining as the USD weakened. Oil prices also rallied, with Brent crude touching a three-year high of above USD 71 a barrel as Organization of the Petroleum Exporting Countries (OPEC) indicated it would extend production cuts.

Outlook and Strategy

After a strong set of corporate results, corporate fundamentals remain strong, despite the recent market correction. Economic data also continues to show a synchronized global improvement. Indeed, we had been anticipating an upward rise in bond yields due to rising inflation for some time, and valuations were increasingly stretched.

With 10 year US treasury yields now above 2.7 per cent, long-absent market volatility has at last reappeared. The sudden spike in the Volatility Index (VIX) was even more dramatic than predicted due to technical reasons. The collapse of volatility-targeting products like Credit Suisse’s inverse VIX exchange-traded note (XIV), has been blamed for exacerbating the situation.

Nevertheless, underlying economic data remains supportive. The euro-zone just posted annual GDP growth of 2.7 per cent, its strongest since the 3 per cent seen in 2007 and just ahead of the US’s 2.6 per cent. Worldwide, manufacturing purchasing manager indices (PMIs) are above 50, indicating positive expectations. Even the Bank of Japan’s governor, Haruhiko Kuroda, observed that inflation was “finally close” to his target of 2 per cent.

Political risk also appears to be taking more of a back seat. In Germany, Angela Merkel’s Christian Democrats are finally in coalition talks with the Social Democrats, widely seen as a positive for Europe. In Asia, North and South Korea’s joint team at the winter Olympics is being seen as a step in the right direction. At Davos, President Trump refrained from making the assault on globalism that many had feared. Even in the UK, the pound (GBP) has strengthened to a level which suggests that some investors view a softer Brexit as an increasing possibility.

For now, this confluence of global optimism and resurgent economic growth should support equity valuations. February’s first week correction is in fact consistent with median corrections going back over 30 years³. However, if inflation appears to be rising more dramatically than expected, equity markets could sell off once again in the expectation of more aggressive central bank rate tightening.

In the event of a major market correction, we expect that the superior nature of those companies in the portfolio will mean they are less impacted than the wider market. Many stocks and indeed, entire sectors, still seem expensive. Because of this, we maintain our strategy of taking profit in some of our highest momentum positions, while increasing allocation to quality stocks that show temporary weakness despite a more positive long-term outlook.

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