April 10, 2017
Investment Outlook 10th April 2017
Investment Outlook 10th April 2017 - A fortnightly look at global financial markets
Broad economic and political assumptions for rest of this year: Euro zone, Japanese and key emerging economies continue to report improving economic data. In the U.S, Trump’s fiscal stimulus and business de-regulation policies will (eventually) pass Congress, but delays will lead to re-assessment of consensus 2017 GDP growth forecast of 2.3%. The Fed will exercise caution in its rate hikes, with two more this year (taking the target rate up to 1.25%-1.5%) and only limited shrinking of its balance sheet. Dollar to strengthen as monetary policy tightens. Trump holds back from instigating a tariff war with trading partners, instead using WTO dispute mechanisms. Oil trades $50-$55 a barrel. Emerging market companies and sovereigns appear vulnerable through the burden of carrying approx $9 tr of dollar-denominated debt, but like Europe and Japan companies will benefit from increased exports to the U.S. The Brexit divorce and subsequent U.K / E.U trade relations talks are held sequentially, as demanded by Brussels, not in parallel, as preferred by the U.K. This increases the risk that the U.K leaves the E.U in March 2019 with no trade agreement, and with trade between the two subject to WTO tariffs. U.K economic data starts to falter as rising inflation eats into real wages. Populist politicians fail to take control in the French elections, with Macron winning the presidency. Angela Merkel less likely to be replaced as German Chancellor by SPD leader Martin Shultz in the autumn, following recent state election victories for the CDU.
Taking the above assumptions into account: We might see equities continue to outperform bonds for the rest of the year, even as stock market volatility (triggered by geopolitics) increases. Euro zone and Japanese stocks may outperform those of the U.S, as a stronger dollar and downgrades to U.S GDP growth lead to lower profit forecasts for American companies. Within fixed income, short duration and limited exposure to high yield might yield the best results, as the Fed tightens monetary policy. Prefer FTSE100 stocks in the U.K to smaller, domestic-focused companies, due to their international exposure. Neutral emerging markets. At the end of this note is an illustration of a standard model multi-asset portfolio, showing neutral positions before any underweights or overweights are applied.
Near-term market conditions: Geopolitics continue to dominate near-term market sentiment, led by the Trump risk premia. His failure to get a Republican-controlled Congress to agree to changes to Obamacare has unnerved investors, who fear that his tax reform and business deregulation policies will suffer the same fate. However his attack on a Syrian airbase, which has been read by some as a warning to the North Korean leadership, and an ‘outstanding’ series of talks with President Xi Jinping last week, does indicate a greater willingness to engage in the world than indicated in his campaign speeches. U.S economic leading indicators have become ambiguous: while consumer confidence jumped in March, far exceeding expectations, the Purchasing Managers Index (PMI) index of business confidence fell slightly and Friday’s March payroll data was weaker than expected. However as we start the new earnings reporting season we should see improved year-on-year numbers from all major economies and key emerging markets, and with improving macro-economic data from much of the world continuing to come in, risk assets such as equities look well supported.
Fed to shrink its balance sheet
- Wednesday’s release of the Fed’s minutes of its March policy meeting revealed that most Fed members expect to see the central bank to shrink its balance sheet this year, as it reverses the quantitative easing (QE) programs it has run since late 2008. The probability is that any shrinking of its balance sheet will be modest, given the ambiguous macro-economic data no starting to appear and the impact on the economy of further rate hikes that are pencilled in an accompanying stronger dollar.
- To shrink its balance sheet, the simplest option is for the Fed to simply sell back to private investors the Treasuries, Mortgage Backed Securities (MBS) and other assets it has purchased fromthem over the years. Since investors will pay for these with cash that could otherwise be lent out, or used to purchase assets in the ‘real economy’, liquidity (ie, the amount of money available in the economy) will be reduced and the cost of borrowing money should rise.
- Between the end of 2007and end of 2016 the Fed’s balance sheet grew from $750 billion to $4.2 trillion as it created money with which to buy bonds, and so reduce borrowing costs in the American (and indirectly the global) economy. Since 2016, it has been reinvesting the interest payments that it receives, and the capital from maturing bonds, into new bond purchases in order to keep its balance sheet stable. A less disruptive method of reversing its QE policy, that would not involve increasing the supply of Treasuries in such a dramatic fashion, would be to not re-investing the interest and capital of maturing bonds.
- The Fed will only do this if the U.S economy remains strong, with particular attention on the housing market given the sensitivity of mortgage rates to changes in the MBS market. In March the Fed’s QE scheme bought 21% of all new MBS debt.
- The risk is that even cancelling the reinvestment scheme leaves too many new bonds in the market, with issuers (such as the U.S Treasury and mortgage finance companies) having to reduce the sale prices -and increase the yields- to attract buyers. How far will yields have to rise? No one knows – we know that QE has distorted government bond markets around the world, but it is impossible to quantify by how much.
- Investors use Treasury yields to value other, more risky, bond markets, and also use them to assess the ‘risk free’ rate by which to value long term dividend flows from equities and hence to value shares. Anything that changes the demand/supply dynamics of the Treasury market, and hence Treasuries prices and yields, is therefore of interest to all investors.
Draghi persuades markets to ignore inflation
- Congratulations are due to Mari Draghi, head of the ECB. Euro zone CPI inflation now stands 2.0%, the central bank’s target rate, while in its largest economy- Germany- CPI inflation is at 2.2%. Some tightening of monetary policy might normally be expected at this point, such as a reduction in its QE monthly bond buying program. This would, in turn, push up the euro. However last week Draghi successfully talked down expectations of a change in monetary policy, fearing higher lending costs will snuff out the recovery. The euro duly obliged by weakening.
- This is, of course, fuel to the fire of those conspiracy theorists who believe that central banks, world-wide, are in tacit collusion with their governments to devalue outstanding debt.
A balanced fund for the long term. The chart below shows a typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor.
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