Asset Allocation: The big picture
So the world economy continues to expand, albeit at quite a modest pace. Many observers remain cautious that this upswing will go the way of all the other post-financial crisis recoveries and run out of steam, perhaps soon. But the synchronisation of these reflationary signs across the world gives others hope that the current growth upturn will be sustained.
For the US, the economy is in the longest recorded expansion phase in its history, and with the US consumer seemingly at the most buoyant since 2001, the US economy is surely approaching its potential – that is, close to both the Fed’s target 2% inflation level and to near full employment. Beyond these stated levels, inflationary pressures have, in the past at least, been seen to rise. The markets appear to have faith in the Fed and so imminent interest rate rises ought not to be a reason to panic.
Chinese policymakers have also been working hard to maintain communication with investors and markets. Current monetary policy is now “neutral with a tightening bias”, thus putting participants on alert that, should asset bubbles start becoming more problematic,v for example, the Chinese central bank, the PBOC, will be ready to act.
Geopolitics remains, arguably, the biggest influence on financial asset prices in the short term. In addition to the (many) unknowns regarding President Trump’s policies and their respective priorities, the political agenda in Europe is packed, and has the potential to cause commotion this year.
France’s presidential election is probably the event with the capacity to cause the biggest shock, although there will undoubtedly be increasing tension the closer Greece’s July 2017 debt maturities approach.
While Treasury yields have been in a tight range since their dramatic gapping up after President Trump’s election win, the slight bull flattening in the curve, combined with tighter credit spreads, a weaker dollar and an exuberant stock market suggest that there has been a significant easing in financial conditions in the US over the past couple of months.
Unlike nominal long yields, inflation-adjusted yields ended their multi-year post-financial crisis decline as the 2013 taper tantrum blew up, taking real 10-year yields in a straight line up from about -0.5% to a new range of about 0.6% by early July 2013. Since then, real yields – on 10-year constant-maturity Treasury Inflation Protected Securities – have remained within a reasonably tight range between zero and 0.5% (with a little spike around the time the Federal Reserve raised rates on 14 December 2016), and certainly show little sign of any breakout to the downside and back into negative.
However, the economy’s reflationary momentum means that, on balance, upward forces remain the dominant domestic economic force on yields. Real rates will, however, only trend significantly upwards if the Fed has to alter its current cautious, and mildly accommodative, approach and moves to a more aggressive hiking agenda. Whether any interest rates, either nominal or real, return to the structural ‘normals’ of pre-financial crisis markets, is perhaps a question for the longer term.
The economic environment should remain supportive for other fixed-income risk markets, albeit with perhaps rather less of the animal spirits aiding equity markets given rising inflation expectations.
Emerging market bonds have performed strongly over the first few months of 2017. Flows data reveal the election of President Trump provided the trigger for many investors to move underweight emerging markets, fearing the introduction of sharply protectionist policies from the new administration. Since that time, however, with so far little substantive information about US trade, and in the absence of other ‘bad’ news, the shorts got squeezed as the market moved higher. There is, however, little sense of exuberance as emerging markets await President Trump’s trade announcements.
It is not just troublesome EU politics that tarnish the appeal of the euro. For the ECB, inflation remains a key part of its challenge to set EU-wide monetary policy. There has certainly been a welcome pick-up in actual, as well as expected, inflation in the zone overall, as measured by the headline figure, Harmonised Index of Consumer Prices. Although it is unclear how high inflation might stay once the base effects of energy prices come out over the course of this year, the threat of deflation has waned significantly.
However, the current dispersion of inflation rates across the euro-zone is wide, and plainly highlights both the economic diversity within the area and the ECB’s difficult task in tailoring a single monetary policy to suit the region’s assorted economies.
With intra-euro-zone spreads also on the rise, largely in reaction to political worries, causing a tightening in real terms for economies that need it least, it is highly likely the ECB will retain its deeply accommodative stance. The euro is unlikely to find any support in interest rates either nominal or real.
Sterling may be on a different trajectory, having already experienced its seismic political wobble and with the UK economy showing resilience. Sterling cheapened dramatically last year across the board, adding to its present attraction, especially versus the euro.
Focus: Restricting trade
At the heart of globalisation is international trade, in particular the concept of free trade between nation states abiding by the rules of the World Trade Organization (WTO). Without strength in global trade, global economic growth often lacks resilience. As a corollary to the world economy’s lifting reflationary spirits, there has been a welcome, albeit modest, pick-up in trade.
President Trump is seeking to challenge the world order on trade, starting by withdrawing the US from the Trans-Pacific Partnership (TPP), stating that he wants “to make our products here again, not bring them in”.
The TPP was not popular in the US and many argued that it did little to help US workers, so stepping away from the deal pleased many Republicans. However, other changes are being mooted which may boost the US economy but could trigger controversy among the trading partners of the US.
Perhaps the most controversial suggestions have come from Republican House speaker Paul Ryan’s tax plan advocating border tax adjustments (BTAs), which are taxes on goods crossing borders – so there would be tariffs on imports into the US and subsidies/rebates on US exports out.
However, Ryan’s BTAs would probably not adhere to WTO rules, would be considered highly protectionist and could trigger retaliation from other countries. It is also unclear that the US economy really would be a beneficiary in the medium to longer term. In the short term, imports ought to fall, exports rise and domestic prices would probably increase.
The prospect of corporate-friendly tax reforms from the new administration have further buoyed US equities and bonds. However, they seem to have put aside concerns about the possibility of BTAs and protectionism fears.