Investors entered 2017 with the anticipation that the Trump administration would usher in a period of fiscal stimulus which could re-accelerate economic growth.
The expected policy agenda and its far-reaching implications for growth, deregulation, trade and geopolitics were the overarching focus for markets as the year got underway. Monetary policy was seen as broadly accommodative and unlikely to derail the recovery. As expectations for increased global growth moved to the forefront, this set of factors has consistently pushed equity markets to new highs. Halfway into the year, it is clear that global economies are enjoying a synchronized cyclical upswing which is driving global risk assets higher.
Despite noise out of Washington, and despite the very limited implementation of the promised fiscal agenda, so far the right tail has largely dominated as fundamentals and largely accommodative central banks drive equity markets to new highs. BNYM continues to believe that elevated risks remain on the left tail which emanate from many sources. There is the specter of a convergence of global tightening that could choke nascent recoveries; moderating inflation; pricey equity and fixed income markets; gross domestic product (GDP) growth that is struggling to achieve escape velocity past the 2% mark; labor market dislocations in developed economies; and geopolitical risks. Further, investors have become complacent since the implementation of extraordinary monetary policy, becoming acculturated to the steady performance of risky assets.
The impediments to implementing the administration’s tax and deregulatory agenda have become quite clear, and with it, a more sober assessment of whether fiscal policy can indeed boost growth. As the Trump agenda has stalled in Congress, the reflation trade has unwound. Yields have fallen, the curve has flattened, and the U.S. dollar has weakened against most currencies. Inflation has dropped to levels well below the Federal Reserve’s 2.0% target.
Contrary to earlier expectations, monetary policy has shown that it still has room to move markets as the Federal Reserve’s commitment to incremental tightening has helped propel markets to new levels. This market reaction is consistent with data that show when rates rise from very low levels, it is usually a sign of economic strength and that strength is reflected in higher equity prices. The downward shift in inflation leaves investors expecting that the Federal Reserve (the “Fed”) will be quite slow in normalizing rates, underpinning asset prices. A similar dynamic is occurring in the UK and Europe.
OBSERVATION TWO: Whither Inflation?
Contrary to signals earlier in the year, readings on inflation have consistently moved away from the Federal Reserve’s 2% target. Near-full employment in the U.S. should lead to acceleration in aggregate demand growth and rising prices for goods and services. The reduced sensitivity of inflation to shifts in economic activity can be attributed to globalization, the reduction in labor bargaining power, and greater labor flexibility.
The changing structure of the U.S. economy has also played a role as technological innovation is disrupting traditional business models in many industries, putting a lid on prices. The technologically driven abundant oil supply coming from the U.S. is an obvious disinflationary force pushing its way throughout the economy.
Investors have reacted to the slowing inflation numbers by assuming the Fed will be largely accommodative, helping push risk assets higher. This expectation is in itself a risk factor as investors have become complacent about the continuation of accommodative monetary policy.
OBSERVATION THREE: More of the Same, but Hope Springs Eternal
U.S. markets must contend with the discrepancy between the soft data which point to expectations of a stronger business environment and hard data which is not meeting elevated expectations. On the one hand, business and consumer confidence remain at elevated levels, which should support domestic demand; on the other, recent data have been slow to reflect that confidence.
Investors had hoped to break free from the era of slow growth, low inflation, and historically subdued interest rates and were looking to fiscal policy as the blunt instrument to do just that. There is no doubt that in the past year, global economic activity has increased with a long-awaited cyclical recovery in investment, manufacturing, and trade. The International Monetary Fund (IMF) projects world growth to rise from 3.1% in 2016 to 3.5% in 2017 and 3.6% in 2018. Stronger activity, expectations of more robust global demand, stronger manufacturing activity in China, a notable uptick in activity in Europe, and subsequent optimistic financial markets are all positive occurrences.2
Despite this, structural impediments remain headwinds to growth. Investors find themselves in a place not much different from the one they had hoped to leave behind — steady if sluggish growth, global low rates, halting inflation, and low productivity. The data indicate that anticipation for a sustained period of 3% GDP growth sparked by the new administration has largely vanished. U.S. GDP is expected to come in around 2.2% for the year, slightly higher than trend. Without a fiscal boost, it will be challenging to push growth to 3% with the U.S. job market already at full employment, historically low levels of labor participation, and slow gains in productivity. Capital expenditure is restrained by the anticipation of possible new tax rules which could improve the treatment of capital expenditure write-offs.
And yet hope springs eternal. The data out of emerging markets and Europe are encouraging. China has delivered stronger manufacturing data. And the U.S. is on an upward growth trajectory, higher than trend, even if not as steep as desired. Corporate earnings are strong and estimates are being revised upward. Rates remain low and policy accommodative, and the possibility of fiscal reform remains as a distant goal. Eurozone sentiment is the highest in 16 years, and recent elections there have had market-friendly outcomes.
OBSERVATION FOUR: Geopolitical Risks Grow
Geopolitical risks come from both the trade and the military side. The U.S. pledge to move away from multilateral international trade regimes in favor of a greater focus on state-led industrial policy and bilateral trade deals lies at the heart of the administration agenda. Recent U.S. trade actions are less punitive than feared, helping lead a rally in emerging markets. Nevertheless, unprecedented uncertainty associated with domestic and foreign policy choices, implementation, and outcomes is likely to be a source of volatility for all asset classes in the near future, even as risk asset markets move higher in the near term.
Heightened geopolitical risks in Asia and Europe and the administration’s preference for unilateral action increase the likelihood for an unintended outcome detrimental to both global assets and geopolitical stability. North Korea’s testing of an intercontinental ballistic missile (ICBM) and China’s unwillingness or inability to reign in the regime stand as major threats to global order and could affect growth in Asian economies. The pulling out of the Paris climate accord has alienated other participants and has isolated the U.S. on the global stage, making it harder to take alliances for granted.
We believe there are three main investable themes for investors.
THEME ONE: Synchronized Global Reflation and Strengthening Fundamentals
Recent data have pointed to a synchronized strengthening of global economies which tends to support growth-sensitive assets, particularly equities. Fundamentals remain strong and there are few signals of a looming recession. Beyond the U.S., economic conditions in Europe and Asia have improved and recent data releases suggest these improvements can be sustained throughout 2017 and 2018.
Equities have historically done quite well in growth environments. BNYM believes that overseas markets in particular, including Europe, emerging markets and Japan are poised for outperformance. While acknowledging that the mood in mid-2017 has softened and investors appear to be taking a more cautious stance on the prospects for acceleration in U.S. growth, it is also true that, counter-intuitively, this sentiment is a necessary condition for risk assets to rally further if growth does indeed improve over the next 12–18 months.
While the U.S. recovery is in its ninth year, other countries are in earlier stages of the economic cycle, particularly Europe, Japan, and emerging markets. Investors looking to boost capital appreciation and leverage cyclical growth are advised to allocate a portion of their capital to faster growing markets, both equities and fixed income. As recovery in European and emerging economies boosts U.S. corporate earnings, investors should look to invest in U.S. and global sectors which benefit from this trend.
The synchronized global growth profile also points to an unanticipated new dynamic — possible convergence, if fitful and slow, in global central banking as the European Central Bank, Bank of England, and Bank of Canada have signaled intentions to tighten in the near future. With no obvious crisis left to fight, global central banks are more confident in growth and no longer need crisis-era monetary policies. A willingness to entertain a tightening cycle means that policy divergence could be on its last legs. Whether or not it actually happens is less important than the signal to the market that global central banks are becoming confident in economic recoveries and are closer to the end of quantitative easing than the beginning. Markets will anticipate and discount future moves.
Fixed income remains very expensive as economies have enjoyed a sea of liquidity for the last few years. A tightening cycle threatens fixed income portfolios with duration risk which is unlikely to be fairly compensated given current price levels. While it may still be too early to call the end of the three-decade bull market in interest rates, we believe the balance of risks has clearly and meaningfully shifted to the upside. This is a risk that directly and indirectly permeates many elements of an investor’s portfolio through exposure to fixed income and other interest-rate-sensitive asset classes. Unaddressed, rising interest rates can jeopardize both the income seeking and capital preservation goals of investors.
We believe that investors should reallocate capital towards unconstrained multi-sector fixed income products and increase global fixed income market exposure. In addition, investors should look to increase holdings of floating rate corporate debt, private debt, and investment-grade corporate credit, laddered bond structures, and other “hold-to-maturity” strategies.
THEME THREE: Continued Uncertainty and Greater Risk of Market Volatility
Policy and economic risks abound. The tension between the hard and the soft data, the pace of rate increases and the risk of over-tightening, fiscal implementation and effectiveness, populism, potential trade disruptions, and geopolitical flare-ups are all sources of tail risk. Most glaringly, the Trump administration has signaled it might 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 reducing cross-border tensions.
The ambiguity inherent in policy choices and the economic data could magnify downside risks to assets globally.
The global economic backdrop has undoubtedly improved but remains vulnerable to a seemingly long list of risks. We expect risk assets to continue to climb the wall of worry, as investors wrestle with the implications of sustained if tepid economic expansion, slow-rising short-term rates, largely accommodative central banks, and unprecedented policy uncertainty. BNYM believes that investors need to evaluate whether their portfolio asset allocations are fully exploiting the market environment while compensating for inherent risks embedded within the market, asset classes, and portfolio construction.
At a time of heightened policy uncertainty, with the possibility that left tail risks dominate market sentiment, and with elevated market valuations for certain equity and credit assets, the markets are vulnerable to a correction. Investors should consider adopting a more unconstrained active approach which can avoid some of the drawdown risk implied by current market conditions.
Diversification, as an investment risk management tool, depends for its effectiveness on the degree of correlation between the asset classes and strategies that comprise portfolios. The evolving policy environment has the potential to destabilize correlations both within and across asset classes relative to the post-2008 investment environment.
Declining correlations suggest that diversification across asset classes and sectors could be an effective risk-management tool.
After a prolonged period of elevated correlations within and across risk asset classes, equity markets and sectors, correlations are falling, and sector-specific volatility is rising. We believe that the moment for active management has arrived. This divergence in performance should support active management. Analysis suggests this is beginning to happen. In a world where expected returns for market risk are subdued, active returns should be more explicitly emphasized as a potential driver of capital growth and income generation for investors.