Elsewhere there is a high probability that the Bank of England, the European Central Bank, and the Bank of Japan will continue to face slower growth than they would like and inflation lower than they would like, and will all be at least maintaining their currently supportive monetary policies, or even intensifying them a bit more again. The Bank of England may well be confronting a U.K. recession, and may ease interest rates or increase its quantitative easing programme (which keeps bond yields low). There are also currently strong market rumours that the Bank of Japan will move to some form of “helicopter money”, where it simply prints money to fund government spending, or even dispenses free cash to other groups.

Investors are therefore unlikely to be faced with an abrupt return of bond yields to historically more normal levels anytime soon, and the risk of the associated sharp capital loss currently looks remote. Government bond yields may continue to provide effective insurance against ongoing volatility, though the scale of capital gains year-to-date is unlikely to be repeated, given finite limits on how far lower already minuscule bond yields can go.

For many investors, given the exceptionally low yields on government bonds, corporate bond yields have been a more attractive option (Morningstar’s Expert Panel has been of the same view). But investors need to be careful about the risk/return package they are taking on. As investors have piled in—the latest Bank of America Merrill Lynch survey of fund managers found that being long U.S. or European corporate bonds is one of the world’s “most crowded” trades—corporate credit spreads have fallen as the bandwagon arrived and bid up bond prices, but at the same time default risks have been rising.

At the start of this year, for example, Merrill Lynch’s index of high-yield U.S. corporate bonds was yielding 8.76%, and offered a yield premium of 6.5% over the benchmark U.S. Treasury yield. Now, the same yield is down to 6.67%, and the yield pickup has dropped to 5.1%. This lower credit spread has to pay for deteriorating credit quality and rising default risk. Ratings agency Moody’s recently estimated that the number of U.S. companies with credit ratings at the bottom end of single-B or below was near an all-time high, and it expects the default rate on U.S. high-yield corporate debt to rise from 5.1% currently to 6.5% by the end of this year.

International Equity - Outlook

Morningstar’s Expert Panel meeting in July had concluded that international equities still warranted a benchmark allocation. Global economic activity continued to progress, though more obviously in the U.S. than in other developed economies, monetary policy (as noted earlier in the International Fixed Interest section) was likely to continue to provide ample liquidity and to encourage investors to look favourably at equities on relative valuation grounds. There were, however, a range of downside risks, and although modest rates of economic growth remained the most likely scenario, investors should be prepared for further episodes of anxiety-driven volatility.

Events more recently have tended to confirm the panel’s view, and particularly the relatively lopsided distribution of growth in the developed world, where the U.S. has been making all the running. On top of a better-than-expected jobs report for June, more recent data on retail sales and industrial production have also beaten expectations. This solid performance by the U.S. economy is not necessarily translating into immediate strong corporate profitability. U.S. data company FactSet, which tracks both companies’ actual profit results and analysts’ expectations for future profits, estimates that profits during the June quarter at the S&P 500 companies were 5.5% lower than a year earlier (2.0% lower ex the energy sector, where the U.S. “fracking” industry has been hard hit by the lower world oil price). But more positively, profits are expected to resume year-over-year growth in the current quarter, and to pick up further in 2017.

Evidently, many investors have been taking a similar view to the panel’s. The latest (July) Bank of America Merrill Lynch global survey of fund managers, for example, showed high degrees of risk aversion, low expectations for global growth and global profitability, and strong regional and sectoral preferences. The risk aversion could be seen from the proportion of cash held in portfolios: While still low in absolute terms, at 5.8%, the level of cash holdings was at its highest since late 2001. Greater anxiety could also be seen in the use of instruments to hedge equity risk. Although most fund managers have still not resorted to taking out hedging protection against equity declines, the proportion taking out protection has reached a new high (continuing a steady trend that started as far back as 2013). The biggest risks they are worried about are geopolitical risk (mentioned by 59%), protectionist risk (52%) and business cycle risk (52%)—the same trio that was foremost among the panel’s top concerns for the coming year.

The fund managers were also more pessimistic about the equity outlook. They are only marginally positive about the global economic outlook over the next year (a net balance of +2%) compared with a much more upbeat net balance of +23% in June, and they were correspondingly more downbeat about global profits, with a net balance of 4% thinking they will deteriorate over the next year, compared with the net 10% last month who expected profits to improve. As a result, fund managers moved slightly underweight to global equities (a net balance of -1%) for the first time since 2012.

The fund managers also have strong regional and sectoral preferences. They are currently underweight eurozone (-4%), Japanese (-7%) and, especially, U.K. (-27%) equities, but overweight the U.S. (+9%) and emerging markets (+10%). When asked which markets they would most overweight or underweight over the next year, unsurprisingly, the post-Brexit U.K. market is again deeply out of favour (-39%), though managers are even highly concerned about Italy (-42%). Although the survey did not indicate the reasons, most likely the highly downbeat assessment represents a combination of higher political risk and severe problems within Italy’s banking sector. By sector, managers are strongly of the view that a higher-risk outlook bodes ill for bank shares, and although they are still slightly underweight commodities (-4%), the degree of underweight allocation has dropped substantially in recent months as oil and other commodity prices have improved.

The panel’s “muddle through” view of the global economy faces some challenges. Although world equity markets appear to have come more to terms with Brexit, it is still not clear how the U.K.’s departure will play out. A recent analysis by the European Commission has calculated that the impacts could range from relatively small (a cumulative loss of 0.3% of eurozone GDP over the two years 2016-17 and a loss of 1.0% for the U.K.) to quite significant (0.6% of GDP for the eurozone, 2.7% for the U.K.). And there are other risks: While investors are currently keen on emerging markets, the latest events in Turkey have shown that severe setbacks can occur virtually out of the blue (Turkey’s bonds, equities, and currency all took large and immediate hits). The most likely outlook is that world equities can continue jaggedly upwards, absorbing reverses on geopolitical or other shocks along the way, but there is a higher degree of uncertainty than usual around that central scenario.

Performance periods unless otherwise stated generally refer to periods ended 20 July 2016.

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