Capital Allocation in Current Markets
In Part I, Economic Outlook, BNY Mellon/Dreyfus discussed three broad Economic Policy Pivots embraced by the Trump administration —
- Pivot One: Shift From Monetary to Fiscal Policy.
- Pivot Two: The Promise of De-Regulation
- Pivot Three: State-Led Industrial Policy and Bilateral Trade Deals
As a result of these pivots embedded within the economic landscape in 2017, we believe these are three main market themes for investors to consider.
Theme One: Global Economic Reflation
On its face, the agenda of lower taxes, infrastructure spending, deregulation and repatriation of overseas cash should reinvigorate businesses’ optimism, encourage greater investment and lead to marginally higher growth rates. Broadly speaking, these conditions, should they come to fruition, should be very positive for growth-sensitive assets, particularly equities. A cut in corporate tax rates should increase corporate earnings, supporting stock prices. Even if the underlying growth rate of the economy does not accelerate, corporate tax cuts alone should be sufficient to support the recent move in equity prices into the next 6-12 months through the impact on reported earnings. Beyond the U.S., economic conditions in Europe and Asia have improved and recent data releases suggest these improvements can be sustained throughout 2017. Notwithstanding the scope for upside growth surprises, the mood in early 2017 has softened somewhat and investors appear to be taking a more cautious stance on the prospects for an acceleration in growth. Counterintuitively, this sentiment is a necessary condition for risk assets to rally further if growth does indeed improve during the course of the year.
Theme Two: Inflation and Rising Interest Rates
The reflationary policies of the new Trump administration, coming on top of recent moves in inflation rates, are likely to send inflation expectations higher still. The starting point of near-full employment points to limited slack in resource markets such that any significant acceleration in aggregated demand growth will ultimately lead to rising goods and service sector prices. Markets have already begun to price in the growing risk of this outlook as medium-term inflation expectations in the U.S. have moved higher, as they have in Europe and Japan. All recent data point to a global uptick in inflation expectations.
The ten-year Treasury yield jumped at the end of 2016 and expectations are that it will move higher in the next 12-18 months as the Federal Reserve, having already raised rates once in 2017, is poised to do so one or two more times this year and possibly hike three to four times in 2018. Fixed income portfolios therefore are faced with duration risk, which is unlikely to be fairly compensated in 2017.
Theme Three: Uncertainty and Greater Market Volatility
Policy and economic risks abound. The pace of rate increases, fiscal implementation and effectiveness, U.S. dollar (USD) trajectory, populism, potential trade disruptions and geopolitical tensions are all sources of tail risk.† Most glaringly, the Trump administration intends to dilute the U.S. commitment to international institutions and global integration after 70 years of post-war leadership. This shift is likely to produce an unstable international climate where previously trusted institutional channels are less effective in lessening cross-border tensions. These policies are a clear source of volatility to markets. With the inability to even place probabilities on process or outcomes, the market is entering a period of “radical uncertainty.” This ambiguity could magnify downside risks to asset markets globally.