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Our economic outlook is one of broad-based, above-trend growth. We have modestly upgraded our expectations for global growth to 3½-3¾ per cent for 2017 and 2018. Stronger global growth will further erode spare capacity, leading to a modest rise in inflation pressures.
We expect US inflation to head back to around 2 per cent by mid-2018, but its return will be more gradual in the Eurozone and Japan. Chinese growth has stabilised after picking up in late 2016, supported by expansionary fiscal policy and continued rapid credit growth. That has supported growth in Asia and other regions that have China as a major export destination. The most notable improvement among emerging market economies, however, has been in Brazil which has finally emerged from a deep recession.
This year has been characterised by low market volatility across asset classes (Figure 1). This is partly a consequence of continued quantitative easing and forward guidance policies from central banks.
However, we think that the turning point for monetary policy is now here. The Federal Reserve has raised rates four times and begun the unwind of its asset holdings. The Eurozone is expected to start winding down QE at the start of 2018 and the Bank of England has indicated that it may raise rates soon. Others are likely to follow in coming years, including the Swedish Riksbank and the Reserve Bank of Australia. The recent example of the BoC is interesting in this context. The BoC removed their forward guidance and raised rates twice, leading to a sharp repricing across the Canadian rates curve. With medium-and longer-dated yields also rising materially, one way to read this is that with more uncertainty about the path of interest rates, investors are demanding a bigger risk premium to hold Canadian bonds.
Within our investment horizon, we are clearly in an environment where the next step for central banks in developed markets is higher rates rather than lower, albeit very gradually. When assessing the potential effects of this change, it is worth remembering the significant impact those unconventional policies have had on global markets. Indeed, while volatility across asset classes remains very low, we are seeing the unwinding of a decade of extremely easy monetary policy. This will have significant consequences for global markets.
The volatility regime remains supressed across asset classes as investors gear towards improving fundamentals. One of the extraordinary features of the current cycle is the amount of liquidity still being created by central banks – notably the BoJ and ECB.
The Federal Reserve has already begun the process of winding down its balance sheet, a process that will pick up pace over the next 12 months. That, in combination with the tapering of purchases by the ECB, should it go ahead as expected next year, is likely to be important for market volatility. One of the objectives of QE programmes was to force private sector portfolio rebalancing along the risk spectrum. This supported risk assets and supressed volatility. There is a risk that the volatility regime that accompanies the removal of liquidity will be materially higher. That said, it seems likely to us that volatility will remain muted over the coming months, provided that our central scenario prevails.
It is widely acknowledged that QE and very low interest rates provided significant boosts to many financial assets. It is therefore understandable that there are concerns that the reversal of such stimulative policies will present a challenge to those same asset prices. However, the withdrawal of policy stimulus is a direct result of improving macroeconomic conditions and that will allow financial asset valuations to become determined far more by fundamental factors than unconventional monetary policy.
It could be reasonably argued that several equity markets around the world have already made – or are making – this transition, being underpinned by much better earnings expectations, again linked to improved economic outcomes.
As far as cross-asset correlations are concerned, some of the changes we have identified in the previous quarters are persisting, or even deepening (Figure 2, Figure 3). We continue to look at the rise in dispersion as part of the ongoing market normalisation process. While the equity to bond correlation has moved sharply lower, we also see signs of changing correlations within equities. For example, that between emerging market and developed market equities has collapsed even more in the last few months.
We observe different behaviour in credit and fixed income markets where yields this year have, if anything, pushed lower, and dispersion has been (and still is) extremely low. This is quite striking in the corporate credit space (as highlighted in the Q3 House View). Better growth fundamentals, a slow return of inflation and gradual removal of policy accommodation mean the path of least resistance for global markets is for higher yields.
While we observe that valuations are not cheap in equity markets, and may now be expensive in some areas, we still find pockets of value and, crucially, we think that fundamental improvement underpin those valuations. Corporate earnings growth in the Eurozone for 2017 is set to be the strongest in years. Conversely, it is difficult to argue that much of the developed market sovereign fixed income universe is cheap.
Overall, our global macro outlook leads us to prefer equities to bonds. We continue to think that our central scenario is also favourable to emerging market assets. Within the equity universe, we are selective, in particular being cognizant of valuations. We prefer being underweight US equities, instead favouring Eurozone and emerging market equities, which will benefit disproportionately from the improvement in world trade (Figure 4).
In the Eurozone, the political backdrop is also now supportive at the same time as growth is establishing itself well above potential in most economies. We continue to think that, further down the road, convergence within the Eurozone is an upside risk to the asset class. Finally valuations remain attractive compared to the US. For many of the same reasons we favour Eurozone equities, we also favour the euro.
Within emerging markets, robust global growth, improving domestic fundamentals and relatively gradual reduction of monetary accommodation in developed markets are all supportive. We also prefer being overweight on local currency debt in emerging markets, where real yields remain much more attractive than developed market sovereign debt. Emerging market hard currency debt provides a much less attractive risk-adjusted expected return. In terms of styles, our central scenario implies some outperformance of Value over Growth (Figure 5).
We see risks for developed market fixed income and therefore prefer being underweight nominal government bonds as well as corporate credit. In the sovereign bond space, our largest underweights are in Japan, UK and Eurozone which are expensive markets and most at threat of a repricing triggered by modest inflation pressures and changing monetary policy.
We balance the sovereign asset allocation by maintaining a preference to be overweight US Treasuries, especially at the long end of the curve which should provide some protection should our central scenario prove to be wrong. We prefer to be short the Australian and the Canadian currencies as a way to protect against key risks such as a sharp slowdown in Chinese growth (Figure 6).
As DM central banks continue to unwind the monetary policy experiment of the last decade, fundamental drivers should re-assert themselves. More dispersion in global markets also means more opportunities for those investors who correctly assess the impact of the removal of extraordinary policies that have driven capital markets outcomes since the financial crisis. Global markets are truly at a crossroads, and we think investors should embrace those changes and position portfolios accordingly as normalisation progresses further.
A visual representation of the strength of our convictions (and therefore positioning) across asset classes.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at 30 September 2017. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Some of the information within this document is based upon Aviva Investors estimates.
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