After eight years of monetary policy distorting the performance of asset classes, this year will be characterised by a transition, in many developed markets, from monetary policy to fiscal stimulus. This regime shift will create interesting opportunities for investors.
Major central banks have started taking the path towards normalisation. Back in December, the Federal Reserve raised rates as widely predicted. The European Central Bank (ECB) announced it will start reducing the amount of bonds it purchases, starting from April, and the Bank of Japan is moving to a yield-targeting regime.
This environment is creating an improved outlook for active managers who have been greatly challenged by extreme monetary policy in the past years. Financial repression, in the form of zero interest rates and quantitative easing, has persistently driven down bond yields. This has been a major headwind to valuation-sensitive active managers. Falling stock correlations as well as rising sector dispersion further strengthen the argument for a return of alpha.
While the current economic cycle has been longer than the historical average, it looks like it will further extend. Recent PMI surveys are pointing to 3 per cent GDP growth this year. In the US, president Donald Trump’s pro-growth agenda may finally lead to a true reflating of the US and potentially of the global economy after years of persistently low inflation. Post-election and into year-end, equity markets rallied and fixed income sold off on the prospects of a boost to growth and higher inflation.
The size, timing and magnitude of tax cuts, healthcare reform, infrastructure spending, deregulation and protectionism is rightly being heavily scrutinised at present. Some of the latest economic data in the US has come out stronger, which indicates the “Trump rally” is more than a hope trade. But one should be mindful of potential legislative and implementation pitfalls that could potentially derail Mr Trump’s plans as well as markets.
Investors have been underweight equities for some time with flows heavily skewed towards bond funds and ETFs. In 2016, fixed-income funds and exchange traded fund generated US$465 billion of flows versus only $29bn in equity funds. Until mid-2016, fixed-income returns were attractive enough to keep investors underinvested in equities. In 2017, traditional fixed income will be challenged by higher rates. Hence, this trend in flows will probably reverse. We have already seen a small reversal, with greater inflows to equities at the end of last year and beginning of this year.
Opportunities will still be found in US high yield, which remains attractive especially given the reduced odds of recession and associated default rates.
An extended economic cycle and global growth are supportive of equities. The question is whether higher inflation and rising rates could actually unsettle markets. Historically, equities have done well in the first part of tightening cycles and have withstood increases in interest rates which reflected improving growth conditions.
Specific opportunities will arise from improved growth conditions and political and policy changes. Mr Trump’s tax reform and deregulation priorities as well as higher rates should be supportive of US financial stocks.
European equities also look positioned for upside. While there are uncertainties ahead, not least a number of political events, these are already mostly priced in by the market and the potential for populist parties to derail the euro-zone story in 2017 may be overstated.
Valuations look attractive and at a wide discount versus the US and earnings have significant upside potential. Furthermore, leading economic indicators are beginning to improve and point to stable economic growth.
Recent weakness in the euro, a central bank that remains highly accommodative on a relative basis and a steepening of the yield curve are all beneficial. Investors looking for opportunities in Europe should identify differentiated companies, with strong business models and low likelihood of being affected by idiosyncratic risks.
There was lower volatility last year as markets did not react much to unexpected events such as Brexit and the US election outcome. The unknowns created by a shift from monetary to fiscal policy will most probably lead to a rise in volatility. Among the risks ahead, on one side markets continue to debate whether tax cuts and deregulation in the US can lift the global economy out of “secular stagnation”. On the other side, an economic danger (but not a central scenario) lies with stagflation fuelled by a rapid rise in rates. The spike in rates would be destabilising for equities, given the higher equity risk premium, and credit, given the flow dynamic.
While investors should be mindful of these risks, the regime shift that is happening has the potential to create a multitude of opportunities at an asset class, sector and style level. Dispersion will be the name of the game this year and a flexible approach to investing will serve investors well this year.
Nicholas Roberts is a portfolio manager and Ilaria Calabresi is a vice president at JP Morgan Private Bank
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