It has been a benign start to the year for investors. Stock markets have reached new all-time highs in the US and delivered strong positive returns across the board globally. Credit spreads in developed markets have tightened slightly, as the search for yield continues, and emerging markets (EM) asset classes have generally performed well. Moreover, the feared collapse in fixed income has not materialized. Sovereign bond yields have mainly been supported by political factors, especially in the Euro area. 10-year German government bond yields ended February little changed from year-end levels, which marks a strong outperformance over peripheral markets that have been hit by growing concerns over an anti-Euro outcome from the next electoral wave. In the US, hawkish comments from Fed members have pushed expectations for a March hike above 80%, but the effect on the long end of the curve has been limited, amid an abundance of domestic and foreign political noise.
Risk Assets Bull Market (YTD Performance)
The improving economic outlook is, in our view, the main driver of this positive investor sentiment. Economic data in developed markets has confirmed that reflation policies are working – not just as potential, but that they are already penetrating real economies. This suggests that the low growth, low inflation scenario could be behind us. The turnaround in price dynamics is quite evident, thanks to base effects also kicking in, but prices are not overheating. US data is consistent with an economy running at full employment. Business confidence has surged (reflecting fiscal reform prospects), while corporate earnings are finally picking up – potentially supporting the cycle of capital expenditure that has been disappointing so far. In fact, a very strong January inflation report indicates that price pressures are materializing before any legislation change has even been enacted! The Eurozone is experiencing a nice rebound in economic activity. With looser fiscal policy and monetary stimulus in place, confidence indicators have been rising among businesses and consumers. Corporate credit is picking up and unemployment is decreasing. In Japan, the economy is on a solid footing, led by external demand and business spending. In the Euro area and in Japan, more decisive fiscal policies could give an additional reflationary boost to sustain inflation dynamics.
Central banks divergences persist as the US economy is at a more advanced stage in the cycle, while there is still slack to be absorbed in Europe and Japan. We expect the Fed’s normalization process to stay on track and deliver the next 25 bps hike in the first half of the year. Meanwhile, the European Central Bank (ECB) and the Bank of Japan (BoJ) are still keeping their monetary stimulus at full speed. The ECB’s current intention is to continue its asset purchases until the end of December 2017, at least. However, QE purchases are unlikely to end abruptly in December 2017, with some further form of less rapid “tapering” likely. The evolution of the political situation in the Euro area may also play a role.
In this scenario, we see the main risks for the future coming from developed markets. In the US, the uncertainty surrounding Trump’s administration is still high. It is not clear how much his protectionist stance will hurt US trade partners and if it could trigger trade wars. Infrastructure spending programs and tax reforms are still to be detailed and markets are getting impatient. The rise in US interest rates is another source of risk. With further acceleration, the Fed’s stance will likely be more hawkish and therefore risks policy mistakes.
European politics are another risk on the radar. In France, a victory for the anti-European Le Pen could trigger further market reactions, such as pricing an uncertain future for the euro and the European Union. The probability of this happening is quite low at the moment but the race for the presidency is still open to all possible scenarios and, after the sequence of unexpected outcomes in 2016, markets are already exhibiting nervousness, for example through higher government bond spreads or higher credit default swaps on the European investment grade market.
Investment Opportunities: Risk Assets with a Focus on Tail Risk-Hedging
Global growth and inflation acceleration should continue to play nicely for risk assets and equities, in particular, are expected to outperform bonds in the next few months.
Equities are the Winners vs Bonds in Reflation
Source: Bloomberg, data as at February 21, 2017. A level of the Citi Surprise Index Above 0 means that inflation has been higher than expected.
In this reflationary setting, we believe investors should continue to focus on growth opportunities through US and Japanese equities. European equities are also attractive in this environment, but Brexit and the outcome of the elections in France constitute an element of uncertainty and so we are more cautious here.
A re-rating of inflation expectations is expected to weigh on long duration bonds and drive a steepening of yield curves. In this context, short duration and global inflation-linked bonds are favored. Pockets of value can still be found in credit markets, especially in high yield. EM bonds can still be seen as a source of income for investors’ portfolios, even though they seem fairly valued and we see limited space for spread tightening in 2017. A flexible and unconstrained approach across the fixed income spectrum can be an opportunity to navigate a phase of rising rates and good growth outlook.
Because of the still present headwinds in the global economy, and because financial markets have raised the bar and disappointment risk is higher, we believe that broadening sources of diversification and incorporating efficient hedging strategies will continue to be crucial to try to protect investors’ assets.