The prospect of low inflation and decent global growth means the outlook remains moderately favourable for risk assets, despite US interest rates having recently risen for the first time in almost a decade, says Stewart Robertson.

Key points

  • The economic backdrop remains moderately favourable for risk assets
  • However, gains in share prices look like requiring better earnings numbers
  • Markets may have to cope with faster than expected rises in US interest rates
  • Emerging markets’ fortunes could at last turn a corner this year

Inflation declined steadily around the world in 2015. That has enabled central banks to keep monetary policy looser than many commentators had expected. That has in turn offered a helping hand to risk assets. However, the unprecedented monetary stimulus that we have seen in recent years looks like it may be drawing to a close. This begs the question: will risk assets such as equities be able to cope?

Inflation likely to remain low

Headline rates of inflation around most of the developed world are close to zero. Although the threat of deflation remains a concern, it is more likely these exceptionally low inflation rates will not persist.

Headline inflation should be back close to 1.0 per cent by the middle of this year, perhaps even higher. This is not, in our view, the start of something more nasty or dangerous. But it merits close attention even so. And the return of even a modicum of inflation could jolt markets, which have got used to very low inflation.

Fed acts on rates

It is because things are finally returning to normal that it was appropriate for the US Federal Reserve (Fed) to start to raising interest rates. But after ten years without a rate rise and experimental monetary policy in response to the financial crisis of 2008, the Fed will want to tread carefully. As rates go up and the world doesn’t come to an end, markets may have to cope with the prospect of them rising somewhat faster than currently anticipated. But it is a long road back. And it will be an eternity before we see interest rates at four or five per cent – the norm in the 80s, 90s and early 2000s.

Trade to pick up

2016 should be another reasonably good year for the global economy. Although the gap between the performance of ‘developed’ and ‘emerging’ economies may close, the latter will continue to grow far faster – around 4.5 per cent compared with 2.0 per cent in the developed world. World trade volumes should recover as it is very unusual to have global trade expanding more slowly than growth for long.

With the Fed delivering on rates at last the dollar is likely to appreciate further. Although a stronger dollar has been a headwind for emerging equity and bond markets in recent years, their fortunes will eventually turn a corner and 2016 may be when this occurs.

Favourable outlook

Some of the wilder gyrations in financial markets seen last year were difficult to navigate. With US interest rates likely to rise further, it looks as if this year will be an equally challenging environment.

Although the outlook for risk assets is moderately favourable, they are starting to face increasingly stiff headwinds. For instance, equity markets are having to price in the fact companies are struggling to grow profits. Further gains in share prices look like requiring better earnings numbers. Tighter monetary policy will not make that task any easier.

Low inflation and steady economic growth should aid prospects for corporate bonds. While high-yield bonds have struggled in the last twelve months, in general companies’ balance sheets are in a healthy shape and defaults will remain low by historical standards. The outlook for government bonds is less rosy with little scope for yields to fall further. We are positive on the outlook for real estate with yields still attractive compared with other asset classes.

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