Key investment themes and risks
House View: Q2 2017
The Aviva Investors House View Forum brings together senior investment professionals from across all markets and geographies on a quarterly basis to discuss the key themes that we think will drive financial markets over the next two or three years. In so doing, we aim to identify the key themes, how we would expect them to play out in our central scenario, and the balance of risks. We believe that this provides a valuable framework for investment decisions over that horizon. In the March 2017 Forum we identified the following key themes:
- Turning point for global monetary policy in sight
- Market outcomes to be increasingly determined by fundamental factors
- Expectations of sustained inflation
- Focus on willingness to use fiscal
- Political prioritisation of national over collective interests
- China growth stabilisation
- Peak regulation
1. Turning point for global monetary policy in sight
The era of extraordinarily accommodative monetary policy across the world is – slowly – coming to an end (Figure 1). The Federal Reserve has already raised rates three times and we expect they will deliver two more hikes this year and a further three in 2018. More importantly, there has been growing acceptance by market participants that this is the appropriate response to economic developments. This is still an extremely slow pace of tightening by historical standards and the more plausible risk case is that more rather than less may be required, either because inflationary pressures increase more quickly or because fiscal stimulus adds to the pace of growth in the US.
Arguably the more significant change recently has been the increasing belief that other Central Banks – the ECB and BoJ – have done as much as they can or should in terms of stimulatory monetary policy. They may now also be considering how to move away from the more radical elements of their policy stance – plotting their exit strategies from QE and negative interest rates. Neither is likely to be in any great hurry to act, but the very fact that such options are even being debated represents a marked change from recent years. Inflation is now close to (or at) target in several countries and the deflationary threat has all but vanished. The return of inflation implies that real policy rates – both actual and anticipated – are still extremely low.
2. Market outcomes to be increasingly determined by fundamental factors
QE is regarded as a blunt monetary policy instrument by many, but one that has been necessary in extreme circumstances such as those experienced during and after the Global Financial Crisis (GFC). A key transmission mechanism of QE has been the boost to the prices of a range of financial assets and the associated suppression of volatility. The combination of this with the threat of deflation has pushed bond yields to exceptionally low levels by historical standards. As Central Banks now retreat from their asset purchase programmes, the distortion to risk assets will fade and asset prices will once again be determined more by fundamental factors. This transition is part of a more general return towards normality in economies and financial markets.
While QE was the dominant influence, correlations between asset prices rose markedly and the general market environment could often be accurately characterised as “risk on/risk off”. As fundamental drivers reassert their importance, this will change again. In particular, markets will have to reassess what the risk-free rate is or should be (Figure 2). Most studies show that the theoretical equilibrium real rate was heavily negative following the GFC, but may now be inching back towards positive territory. This theme is closely related to two others. As we move away from the zero bound on policy rates (#1) and as it becomes more widely accepted that inflation has returned or is returning (#3).
3. Expectations of sustained inflation
In the wake of the financial crisis the threat of secular deflation felt very real. There is now a growing conviction that the danger has passed. Headline inflation is now at or close to target in the US, the Eurozone and the UK. It is still low in Japan, but is at least positive (Figure 3). Expectations of future inflation have also returned towards rates that prevailed pre-crisis when there was a widespread acceptance that Central Banks would achieve their inflation targets – generally around 2 per cent.
This may seem a small change, but it is an important one. As recently as the start of last year, the deflationary narrative dominated market dynamics, particularly bond markets. That is no longer the case. The rise in inflation has not been confined to developed economies – the trend has been seen in many emerging nations as well, including China. Part of the explanation has been the stabilisation and subsequent rise in energy and other commodity prices, but part has been more fundamental. Even so, “core” inflation rates (which exclude energy and food prices) remain more subdued, particularly in the Eurozone and Japan (Figure 4). The belief in the return of inflation is a key step on the road back to normality, but until or unless core inflation starts to drift higher too, there is good reason for central banks to tread carefully.
4. Focus on willingness to use fiscal
During the GFC almost all countries engaged in massive fiscal expansions, either through active policy decisions or as a result of automatic fiscal stabilisers. Subsequently it was generally accepted that fiscal discipline had to be re-imposed and that “austerity” was the appropriate course of action. Attitudes now seem to be changing again, despite high levels of public debt. Budget deficits are currently far lower than at the peak of the crisis, but are still high by historical standards. Yet it has become acceptable to propose and initiate looser fiscal policy as a means of stimulating growth. Although details are still sketchy, a fiscal boost in the US under Trump’s administration is expected this year or next.
A new expansionary fiscal package is also plausible in Japan. Even in Europe, where fiscal prudence were the watchwords for many years, a more relaxed attitude towards fiscal expansion has prevailed (Figure 5). If deficits were to spiral higher again, this could change. But for the moment, fiscal policy seems more likely to add to growth than to limit it. The UK is a special case where any signs of a Brexitrelated slowdown would probably be met with a fiscal boost. In China, the official budget deficit target of 3 per cent of GDP this year, alongside stimulus from other quasi-fiscal measures, suggest growth will be underpinned there to ensure they meet their GDP target of 6.5 per cent or more.
5. Political prioritisation of national over collective interests
With Donald Trump now installed as President of the US, the issue of the pursuit of national as opposed to collective interests is unlikely to slip from the headlines for very long. It is early days, but it seems plausible that some of the more extreme versions of his populist agenda will be appreciably diluted. Others might even be shelved and conveniently forgotten. Even so, nationalist themes are likely to feature extensively in public debate in the US and elsewhere over the next few years. In Europe we have seen the first important election this year – in the Netherlands – which saw the ruling centre-right party retain power. The far-right candidate did increase his share of the vote, but by much less than had been expected.
The focus in Europe has now shifted to France and, after that, Germany (Figure 6). Marine Le Pen is extremely unlikely to win in France, but she is almost certain to make it to the second round. The rise in nationalism/populism represents a small, but rising, threat to harmony in several nations. For example the present government in Italy may not last until the next scheduled election, and while opinion polls suggest the country would vote to remain in the EU and euro at present, the gap has narrowed. Self-interest is also certain to feature in a major way in the Brexit negotiations.
6. China growth stabilisation
Growth worries at the start of 2016 led China to introduce a range of credit and fiscal policy initiatives aimed at achieving their GDP growth target of 6.5 - 7 per cent. This was successful (growth was 6.7 per cent last year). Now their priorities seem to be shifting slightly again. They will not wish to put their growth target of 6.5 per cent or more at risk, but they do seem to be trying to tighten policy modestly at the margin, reining in the credit impulse and returning to the (slow) reform and economic transition agenda. As always, this process will be managed tightly, especially so this year as the authorities will strive for stability between now and the 13th National People’s Congress in November.
Once the new leadership for the next five years is in place there will be greater freedom to concentrate on the economic agenda, but also – perhaps – to reprioritise reform. On the sensitive currency issue, we anticipate that China will continue to manage a slow but steady depreciation of the renminbi, similar to the last two years (Figure 7). This issue is especially important in the context of relations with the US, and the previous Trump threat to label China a currency manipulator. Any moves towards greater global protectionism are also relevant here.
7. Peak regulation
The raft of greater financial regulatory requirements introduced over the last decade was an understandable response to the GFC. And doubtless they will have made the financial world a much safer one for investors and set in place an environment in which the worst excesses from that crisis cannot be repeated. Wellintended regulation can, however, sometimes result in excessive interference that prevents markets from functioning as they should. There is now a groundswell of opposition building against further regulation and even in some circles of reversing some parts of previous decrees.
Reduced regulation is most likely in the US, where Trump’s administration has a stated goal to ease the regulatory burden and free up institutions to allow them to operate more effectively in the future. It remains to be seen whether other countries follow this lead. Across Europe there is much less interest in a lighter regulatory touch, with the final elements of Basel III expected to be phased in over the next two years. Even so, the idea that we have passed the point of “peak regulation” seems creasingly likely.
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