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Three months ago we discussed the idea that peak policy easing was behind us and that a higher volatility regime lay ahead. Our central scenario remains one of strong global growth, leading to modestly stronger inflation pressures. In that context, the direction of travel for the main G10 central banks is biased towards tighter policy. One consequence of this view that we have highlighted in previous quarters (in hindsight probably a bit early) is that fundamentals should be back in the driving seat and that the low volatility regime will come under pressure (Figure 1). The return of fundamental drivers is impacting different asset classes in alternative ways and at a different pace. But while we have seen a lot of dispersion in equity markets, fixed income assets have shown far less. This is unlikely to continue, especially as we expect the ECB to halt asset purchases this year and the Bank of Japan to potentially modify their yield curve control policy in the second half of this year or in 2019. This comes on top of an expected four rate hikes from the Fed this year and a further four in 2019.
More dispersion on average and across asset classes is likely to be the new norm, and in this world investors may wish to be more granular and active than was the case in the quantitative easing era. We are clearly progressing along the road of normalisation and leaving behind a decade of almost zero interest rates policy and excess liquidity (Figure 2). It is not surprising that it is taking time for global markets to adjust to the new state of affairs. Although such adjustments are not always smooth, fundamentally it should be regarded as a positive development. The robust growth backdrop, which is expected to continue, is helping markets to stand on their own two feet again.
We remain generally constructive on global equity markets. But expectations of a higher volatility regime lead us to favour a small reduction in equity exposure, while still remaining overweight. Indeed, an alternative way of positioning for strong growth, the return of inflation and the changed monetary policy stance is to be aggressively underweight duration in developed markets.
A higher volatility regime is arguably a good thing for global markets. What was less healthy was the almost uninterrupted rise in equity markets accompanied by extremely low volatility. We now think that global markets have regained some ability to price risk. Again there is some differentiation to be made across asset classes. In the past few years, foreign exchange markets in general have been more successful in pricing in the main macro-economic developments.
In that context the US dollar depreciation over the past year or so is interesting. While the monetary policy differential between the US and the rest of the world argues in favour of a stronger dollar, global markets are factoring in the rest of the world catching-up (signalling the turn in monetary policy in the UK, Japan and the Eurozone) and other factors such as concerns around fiscal discipline in the US. We continue to look at currencies as providing risk-reducing positions which should protect portfolios should we be wrong in our central scenario. We find being short the Australian dollar an attractive position, since it provides protection in a number of scenarios (Figure 3). Being long the Japanese Yen also works well in a number of downside scenarios, and interestingly it is likely that future policy from the Bank of Japan will be supportive of the Yen, a marked contrast to much of the last few years.
Emerging markets remain our preferred area, both in equities and local currency debt. The environment of strong growth and, crucially, a benign dollar, alongside still supportive valuations, mean that emerging market assets continue to look attractive. We still prefer local currency debt to hard currency debt on valuation grounds, however as we reduce exposure further in developed market fixed income, we upgrade hard currency debt from underweight to neutral.
We have neutralised our underweight on US equity markets as we expect earnings growth to remain strong, with share buy-backs potentially giving more support to the market. As a result, we have rebalanced our exposure in other markets and reducing slightly our European and Japanese exposure. One potential headwindfor both these markets going forward could be the currency, as the environment in terms of monetary policy is supportive for both the euro and the Japanese Yen (Figure 4). Sector wise, we continue to like global financials as an expression of our reflation views, also helped by lower sensitivity to currency moves than the broad market. We remain underweight UK equities as uncertainty around Brexit still makes the risk-reward balance unattractive.
The key element underpinning our asset allocation view lies in our view on duration. We note that although bond yields have risen, overall financial conditions remain loose (Figure 5). We think duration should be an aggressive underweight both in the sovereign and credit space in most developed markets. The most acute threats for duration lie in Japan and the Eurozone for sovereign bonds, while we see US Treasuries as neutral at best. We continue to use duration in Australia as a risk reducing position which should do well if we are wrong in our central economic scenario. The domestic situation in Australia, with rising risks around the housing market, is also a key driver of this position (and of our short Australian dollar position). Corporate credit remains a strong underweight. As spreads remain relatively tight, we find the asset class offers little expected return going forward, most notably in the US and in Europe.
One step closer to normalisation
While global markets are still climbing a wall of worry (the most recent contributor being the trade policy initatives coming out of the White House), the longer term anchor of our central scenario is a world of strong growth and modest inflation pressures. Markets are taking more steps towards normalisation as we slowly exit from the decade-long experience of experimental monetary policy. The euro and yen currencies are likely to take the batton from the US dollar as appreciating currencies. This favours taking exposure in emerging markets, and being underweight duration. In many ways, risk scenarios seem to be more and more centered around debt markets, be it fiscal discipline both at sovereign and corporate levels, debt deleveraging, active central bank tightening or higher volatility regimes.
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