Until late last fall, the key adjective used to describe global markets was “lower”: lower interest rates, lower inflation and lower growth. The list goes on. But as my colleague, Joe Amato, observed in his CIO Weekly last week, “Hopes and Fears,” we are finally beginning to see the return of the business cycle and economic expansion. Indeed, the mantra today has switched from “lower” to “higher”: higher interest rates, higher inflation and higher growth, to name but three examples.
Today, we’re in a broader, reflationary market that’s likely to produce an economic environment that’s more supportive of risky assets. The move by President Trump last Friday to start relaxing elements of the Dodd-Frank Act is just the latest example of one of the many drivers that are potentially supportive of markets. Against this more favourable backdrop, stock markets have risen, investor sentiment is improving and growth is returning.
However, while the overall environment is positive, some of these perceived benefits may yet turn out to be double-edged. In the US, for example, higher interest rates and a rising dollar could dampen or even choke off growth. In Europe, meanwhile, where monetary stimulus is also waning, the political headwinds are increasing, leading to greater uncertainty. And in Japan, there’s a need for higher wages and improving consumer confidence.
In fact, it’s highly likely that there will be uncomfortable periods this year during which investors, both in the US and globally, experience the negative impact of tightening before they see higher growth. In some ways it’s like a tug of war between the cyclical upswing in growth — driven by fiscal reform, deregulation and so on — and the tightening elements that are also beginning to emerge. The most recent example of this tug of war was last Friday’s US payroll data: Job numbers increased, but wage growth weakened.
We’ve seen disconnects such as this in the past, most recently in the bond market last year. But there’s a real question in my mind as to how investors react to them. True, there has been a reality check over the last few days as markets paused for breath in the wake of the US. Federal Reserve’s decision to leave interest rates unchanged. But the general direction remains upward, and investors around the world are beginning to take notice, as illustrated by the outflows from bonds into equity markets over the last few months.
Internationally, there is a globally coordinated upswing, albeit patchy in places. Again, at face value this is a positive development. Over time, however, the divergence across regions and asset classes that already exists could become more exaggerated. And the continued rise in populism coupled with the raft of political elections taking place in Europe and elsewhere this year could exacerbate matters still further. Market volatility has been missing recently. But we fear it will rear its ugly head again — an unwelcome development for investors not prepared for it.
Steady as she goes
We think that rather than fixating on volatility and politics, however, it is important to focus on fundamentals such as earnings growth, dividend yields, interest rates and inflation. It’s also critical to identify the key drivers behind risk assets and understand them. And, as I said back in November on the eve of Donald Trump’s election, at times like this it’s important to maintain a long time horizon, hedging your risks where possible and looking to adopt contrarian positions when appropriate.
At a portfolio level, there’s much to be said for keeping some of your powder dry in the event of new and better opportunities becoming available or, in the event of volatility, buying assets at attractive levels.
Erik Knutzen, Chief Investment Officer — Multi-Asset Class, Neuberger Berman
