Moreover, in a large majority of the developed countries, not only has fear of deflation continued to fade but inflation has not headed for levels that would worry investors.
In 2017 the markets already reaped the rewards of this “Goldilocks” scenario, and therein lies the main reason why our view has grown more cautious. Given the expectation of a continuing rise in companies’ earnings and a very low default rate in 2018, the conditions are ripe to invest in stocks and corporate debt. On the other hand, we believe that the prospect of a payback on the interest rate risk is too low and warrants a more guarded approach to the valuation of all financial assets.
"Although central banks have so far only tiptoed towards normalising their monetary policies, the movement is gaining momentum and progressing on a wider front."
Edmond de Rothschild Asset Management
Chief Investment Officer
2017 was a banner year for the markets
Few years in stockmarket history could compare with 2017. Financial assets basked in a combination of economic growth that steadily spread throughout the world, accompanied by a mild pickup in inflation and friendly monetary policies. This led not only to double-digit performances (dividends included) for most of the leading equity benchmarks but also to remarkable returns for bond investors, despite historically low yields due to narrowing credit
Can such conditions last?
Although central banks have so far only tiptoed towards normalising their monetary policies, the movement is gaining momentum and progressing on a wider front. The Federal Reserve already ended its programme of asset purchases in December 2014 even though US inflation had failed to reach its target of 2%, as measured by the consumer price index. Since then the Fed has slowly returned to a neutral policy by raising its key interest rate 0.25% in 2015 and again in 2016 before tripling the pace of its upticks in 2017. Janet Yellen, the Fed Chair who is due step down at the end of January, will also leave behind the start of a very gradual, clearly segmented reduction in the US central bank’s balance sheet.
The Fed was tightening alone for a year and a half before the Bank of Canada and then the Bank of England started moving in the same direction. The European Central Bank (ECB) has since taken a notable step by halving its monthly asset purchases, from EUR 60 billion to EUR 30 billion from January 2018, but says its monetary policy will remain expansive this year (Its key interest rates will stay unchanged and the QE1 programme will continue until September at least). The Bank of Japan does not plan to budge any time soon on its ultra-accommodative policy while, in the emerging countries, most central banks are also keeping rates low although credit conditions have tightened in South Korea and China.
The big questions in 2018 will be how and how fast monetary policies return to neutral. The global economy is now back to where it was in 2011, i.e. before the European debt crisis, the slowdown in China and the pall this cast over the other emerging regions. Commodity prices reflect the general upturn but are also driving up costs. In the developed economies, the impact of raw-materials costs has been blunted by the predominance of services, but normally such increases work the same way as wage growth. Fed Chair Yellen has called the moderation of US inflation a “mystery” and actually it may only be temporary—an offshoot of this highly atypical economic cycle. For the moment the markets appear to be underestimating the risk of a surge in prices.
The exceptional endurance of the US upturn is due to the modest pace of growth and inflation. There are no imbalances that pose a direct threat to these Goldilocks conditions at this stage. In contrast strains are starting to be seen in the labour market. In November annual wage growth was running at 2.4%, yet the Atlanta Fed’s leading indicators reached 3.4%. US companies are not only having trouble recruiting but are also struggling to hold onto their staff. Continuing strength in job creation can only aggravate these tensions.
The broad-based rise in oil prices, other commodities, wage costs and rents will not feed through as a surge in inflation because of the persistently moderating influence of globalisation-related competition, population ageing in the developed countries and price depression in technology. However, this moderating influence will no doubt abate.
Asymmetric interest rates
Long-term interest rates are undoubtedly the main risk facing investors in 2018. There is a mismatch between implied inflation expectations in the bond market, the level of real interest rates and term spreads2, on the one hand, and the surprising buoyancy of the global economy and the moves by central banks (however mild) to normalise their monetary policies, on the other. Since the beginning of 2017, US yield curve flattening has stemmed from rising Fed Fund rates and falling yields on 10-year US Treasuries. This followed a period at the end of 2016 during which long bond rates rose.. This flattening trend could be a source of instability for the bond market.
Fed officials have issued numerous statements on their intention to return to a neutral monetary policy very gradually. Besides the December hike in the federal funds rate to 1.50% (the third uptick in 2017), and the decision not to reinvest redeemed bond capital systematically, the markets expect three more 25bp rate hikes in 2018. A change in the inflation outlook could alter the Fed’s plans, which are above all pragmatic but stem from a situation that was different from the one we have today.
Over the past five years, long-term interest rates have risen three times by more than 50bp in the space of a few weeks: in Q2 2013, Q2 2015 and Q4 2016. In our view there is a significant chance of the same thing happening again. These increases in long-term rates were much less gradual than the concurrent hikes in short-term rates implemented by central banks. Actually monetary authorities would not necessarily disapprove of steeper yield curves, which would reflect an upturn in inflation expectations and allow them more wiggle room.
Europe is behind in earnings growth and stock valuations
A fit of volatility and uncertainty in bond markets would no doubt affect credit spreads and equities. This was already the case in 2013 and 2015. The fact that the pattern did not repeat itself in 2016 is probably due to the more reasonable level of stock valuations after the markets’ troubles early in the year. But we think a new spill-over this year, if it comes, will undoubtedly be an opportunity to buy risk assets at better prices. It is when the markets wobble that indicators of fundamental quality reveal their merits again. Companies’ revenue growth provides operating leverage and greater price elasticity reduces downside pressure on margins, boosting earnings growth.
With this prospect in mind, we should remember that equities in Europe are less richly valued and thus have more upside potential than in the US. Nor has the business cycle reached the same stage of normalisation, so markets on this side of the Atlantic have not yet reaped the same benefits. After years of recession and slow growth, observers are still sceptical about the current recovery. And yet, as illustrated by the latest reading of its composite Purchasing Manager’s Index (PMI) (58.1 points, the highest level in 83 months), the eurozone is benefiting more from the global upswing than America is. It is lagging in the monetary cycle as well. The ECB has edged towards ending its unconventional policy measures but is still a long way from adopting a neutral stance.
Japan, despite just recording its seventh consecutive quarter of positive GDP growth, is easily the country that stands furthest from monetary normalisation. Investors have the same misgivings about Japan’s outlook as they do about Europe’s.
The decline of the US dollar in 2017 helped the perception of emerging markets. After slumping the year before due to uncertainty, economic activity mounted a remarkable comeback across most regions fuelled by fresh inflows of foreign capital. Domestic difficulties linger, however, beginning with crushing debt in South Korea, Malaysia and Brazil. Renewed dollar appreciation would make it harder for these countries to manage their external debt. Following the re-election of Xi Jinping as head of China’s Communist Party, a move by the Beijing authorities to rein in lending would curb the growth of those countries which are most dependent on China’s mini-cycles.
Conclusion: normalising does not mean tightening
After years of unconventional monetary policy measures throughout the world, central banks’ nascent normalisation should not be equated with a restrictive stance. Their shift towards more neutral credit conditions gives a clear advantage to equities over bonds.
However, exiting from such an exceptional period is no doubt the real test of central banks’ technical expertise and, more importantly, their skill in communicating with investors. The situation is unprecedented, providing scope for greater volatility. This will require more vigilance and, in turn, less passive allocations and more stringent stock picking.
Chief Investment Officer
Edmond de Rothschild Asset Management
1Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
2The component of interest rates which reflects neither monetary policy expectations nor a credit premium.