The monetary policy cycle is starting to turn, but global markets appear strong enough to cope.
Introduction by Christian Nolting, Global CIO
In this late cycle economy, policy change, combined with apparently high valuations in some asset classes, might appear to suggest a tough road ahead for global markets. But I think that they are strong enough to cope, at least for the time being, for three reasons:
The global economy: Recent data has been generally good if not stellar. The U.S. appears to be on course for 2.1% growth this year, European data suggests a continued gentle acceleration in growth, and a slowdown in Chinese economic expansion has been less marked than generally expected.
Continued policy support: Even after the Fed’s quantitative tightening (QT) is ramped up, it will still take three or more years to get its balance sheet back down. The other major central banks are still several years behind. So the hill thrown up by QT may be long, but it is unlikely to be very steep.
History: It suggests that this current late cycle environment could run on for some time, and that risky assets often do well in such an environment. Market setbacks tend to be short-lived during times of a positive macro environment and solid corporate earnings growth, as at present.
Even so, while there are good reasons that economic and market momentum is likely to be maintained, we need also to realize how the investment landscape is changing. We can already observe that high levels of correlation both between and within asset classes and regions have now fallen back. Lower correlations will create opportunities as investors focus again on the fundamentals surrounding individual markets and assets, rather than on central bank progress. This could be seen as a key staging post on the way to the “next normal” investment environment.
When we started this year, we talked about the difficulties of transforming political promises into action and policy issues around this still seem to us to be a more immediate but manageable challenge.
In short, we expect forward momentum to be maintained, even if with some bumps along the way.
Macroeconomics: healed but not cured
In our last report we noted that, despite all the policy intervention of recent years, the focus was still on slow, cyclical healing, with a very gradual pick-up in economic growth expected.
In the U.S., continued jobs growth has brought the economy close to full employment (structural unemployment) and continued above-potential growth is likely to complete cyclical healing. Recovery is being assisted by sound household and business finances, still-accommodative financial conditions (even after Fed tightening), regulatory reform, and modest tax and spending initiatives.
Eurozone growth also appears to be ticking along nicely, with both business sentiment indicators (such as purchasing manager indices) and hard data looking generally positive. Political risks also appear to be fading – except for Brexit and possibly Spain.
The UK is now lagging Eurozone growth as Brexit uncertainties have an impact. Japan is on the up, with strong recent quarterly growth rates and an evident recovery in household incomes and expenditure. The labor market is tight here too, with corporate sentiment improving and investment with it.
China and the emerging markets
Rising private consumption appears to be bolstering growth in China too, despite evidence of slowing wage growth and anecdotal evidence that the savings rate is falling. Emerging markets as a whole are being helped by strengthening global export demand as well as (at least in Asia) rising consumption and investment. Here too, inflation is generally under control.
Remaining risks to recovery
These include policy disappointment and political turmoil in the U.S., as well as possible over-tightening by the Fed. The European Central Bank (ECB) could also surprise on the hawkish side, although prolonged QE and a deeper negative deposit rate might in fact create more risks, including through asset class bubbles. It is difficult to be completely relaxed about the impending Italian elections, too. In China, there are domestic policy risks as well concerns about a U.S. trade war.
Multi-asset: not too hot, not too cold
Allocation in the “artificial Goldilocks scenario”
In the immediate future, we expect solid global growth accompanied by relatively low inflation.
This will prompt central banks to move forward with gradual policy normalization. Hence, we expect a generally supportive investment environment for risky assets, albeit with periods of volatility.
Equities – Despite the high valuation levels, record low volatility and the length of the current cycle, we still think that there are further gains to come.
Fixed-income – We remain cautious on high yield, given the matured cycle, low spreads and the likelihood that volatility/illiquidity picks up from current levels at some point.
Emerging markets fixed income – Given the upwards economic trend in many emerging markets, this sub-asset class is apparently well-positioned to absorb policy normalization by the Fed and the ECB.
Commodities – Given our expectations that oil prices will not increase markedly, and that gold price rises are likely to prove temporary, we maintain only a relatively small allocation to commodities.
Late-cycle investing and low volatility
Low-volatility periods can last longer than expected, with periods on the S&P lasting 22 months on average, and sometimes much longer. The current observed period started 15 months ago.
Rates volatility is well below average and implied credit volatility is also at post-crisis lows. Credit and equities also tend to have above-average returns in low-volatility periods; distracting attention away from a reduction in cross-regional and cross-asset class correlations back to near post-crisis lows.
History (based on the S&P 500) suggests that when the current low-volatility period comes to an end equity volatility tends to pick up, but not to move to very high levels very quickly. Equities can fall back, but there is often a period before a major drawdown.
Returns & risk management
Aggressive monetary policy action has been highly supportive of equities since the “Great Recession”: as it is gradually normalized, the price/earnings ratio (amongst other factors) could fall back. This policy change could also create headwinds for investment grade and high yield.
Equities: keeping the faith
Investors have kept their faith in equities, even during a period where seasonal factors can take their toll. This year, the usual “weak season” has turned out to be very positive.
U.S. market gains keep valuations in focus
Earnings posted in the first two quarters of 2017 mean that full-year earnings predictions should be rather straightforward to reach. However, with U.S. price/earnings (P/E) ratios above their long-term average, valuations require care. While a temporary correction is possible, the U.S. stock market is likely to be kept underpinned by solid economic growth data and might eventually benefit from some belated policy reforms.
Concerns around automotives in Germany
In Europe, equity valuations appear cheaper and equity markets hold some promise in view of the ongoing solid macroeconomic fundamentals that underpin the upturn throughout the continent. In Germany, the DAX index began Q4 by touching new highs but the equities outlook is clouded by the automobile sector and the uncertain outcome of the "Dieselgate" scandal.
Yen worries for Japan
Japan has shown improvement as well, despite the strengthening of the Japanese yen over the course of this year. We do not expect sustained further gains and many Japanese companies appear in good shape.
Emerging Asia keeps benefiting from strong economic fundamentals and sensible equity valuations. Asian corporate earnings upgrades bode well for the future development of local equity markets. We expect further increases in earnings next year.
Technology leads our sectoral preferences
Our preferences lie with cyclicals such as materials, financials and technology:
- Materials are likely to benefit from the ongoing strength of the economic cycle.
- Financials would also benefit from the expected further increase in interest rates in developed markets, led by the tightening cycle in the U.S., but probably followed soon by the U.K.
- The technology sector may be well underway and very conspicuous as a long-term trend – but in our view it also has much further to run and is a key long-term theme for us.
Looking forward, artificial intelligence is likely to have a profound impact on corporates, equity markets and, ultimately, economies. We are neutral on consumer staples, health care, consumer discretionary, industrials and energy, as we see these sectors evolving in line with the market rather than promising to break out. We consider real estate, utilities and telecoms as sectors to underweight.
Fixed income and foreign exchange: normalization on the never-never
The markets are getting more relaxed about central bank policy changes and appear almost reconciled to an ECB tapering announcement in coming weeks.
What underpins this lack of concern? A realization that even after Fed quantitative tightening (QT) and ECB tapering, monetary policy is likely to remain very supportive for a long time to come.
In the Eurozone, we do not think that any rate hikes are likely over the next 12 months, but we do expect cuts in quantitative easing starting in January. Buying could stop sometime in the second half of 2018 but the ECB’s balance sheet will stay substantial and stable for a long time after.
The Bank of Japan (BoJ) is likely to maintain an even more accommodative monetary policy, although the focus could be increasingly on yield curve control. The BoJ still has a big task ahead in reaching its 2% inflation target and appears more than willing to be behind the monetary policy curve.
The result of this very gentle tightening of policy is likely to be only a modest rise in yields in developed government bond markets – our 12-month forecasts for 10-year yields in the U.S., Germany and Japan are 2.6%, 0.8% and 0.1% respectively.
Tighter investment-grade spreads
With investment grade credit, we have tightened our 12-month spread forecasts to 90bp for both the U.S. and Europe (Barcap U.S. Credit vs. Treasuries and iBoxx EUR IG). On U.S. investment grade, we see tighter long-term spreads ahead, although periods of volatility are likely.
We also think that there is room for tighter investment grade spreads in Europe, and believe that it would not be in the ECB’s interest to trigger a sell-off in European fixed income markets through changes to its corporate sector purchase program (CSPP).
Cautious on high yield
European issue volume is sharply up year to date, and U.S. issuance has modestly increased. Meanwhile, the quality of U.S. and European high-yield credit statistics has continued to improve. The U.S. high-yield default rate is expected to fall to 2.75% for 2017 and European default rate is likely to be well below this.
Even so, oil price volatility could have an impact on U.S. high yield and other tail risks (including Fed and ECB) could pose a risk to both markets. High-yield fund inflows could also be peaking and in Europe the yield on high-yield debt is now below the EuroStoxx 50 dividend yield.
Emerging markets fixed income
By contrast, it is easier to see value in some emerging markets fixed income. Many countries have a stable or improving economic outlook and stable deficit indicators. Several external risk concerns (e.g. U.S. rate hikes, Chinese growth, U.S. dollar strength, commodity prices) have also not materialized quite as expected so far – although U.S. political developments could still be a threat. But you do need to be selective, both about geographic markets and also types of debt.
Have we seen peak Euro?
Having hit a recent peak of 1.20, the EUR vs. USD exchange rate had fallen back to around 1.17 in early October and seems likely to fall further: our 12-month forecast remains at 1.10. During its appreciation in mid-2017 the value of the EUR vs. the USD had completely disconnected from interest rate differentials – usually a key determinant. As the Fed raises rates, markets are likely to pay more attention again to interest rate differentials, to the U.S. dollar’s advantage.
Past performance is not indicative of future returns. Forecasts are not a reliable indicator of future performance. Edited from CIO Insights Q4, produced in October 2017.