Key investment themes
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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 June 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
- Expectations of large-scale fiscal stimulus fade
- Political prioritisation of national over collective interests
- Opportunistic Chinese reform
- Peak regulation
1. Turning point for global monetary policy in sight
After a remarkable decade for monetary policy, we have reached a significant turning point for central banks. With sustainable and broad-based growth entrenched and with the return of more convincingly-positive inflation, the slow removal of extreme stimulus is now becoming appropriate. The Federal Reserve has already raised rates four times. We expect a further hike this year and three more in 2018. This is still an extremely slow pace of tightening by historical standards. The Fed has signalled its intention to continue to raise rates gradually despite a couple of recent softer inflation prints. Financial markets do not believe that the Fed can deliver even this pace of tightening.
Elsewhere, we are at the end of the line for additional monetary stimulus and are shifting focus to the way in which central banks will exit their present radical stance. The Bank of Japan (BoJ) has indicated they are unlikely to do more, while the European Central Bank (EC) has tapered asset purchases and is publically discussing its exit strategy. Spare capacity in the region means there is plenty of scope for strong but non-inflationary growth, so they can proceed cautiously. Even in the UK, some policy-makers think interest rates should already be higher because of the inflation spike, despite mounting evidence of a growth slowdown. In passing it is worth noting that the return of low but positive inflation means that real policy rates – both actual and anticipated – are still extremely low (Figure 1).
2. Market outcomes to be increasingly determined by fundamental factors
It is generally accepted that QE (and ultra-low interest rates) boosted the prices of many financial assets significantly. Understandably, there are now worries in some quarters that the end of QE and eventual increase in policy interest rates will remove a key support to such assets and result in some disorderly falls. Fortunately, it looks as if asset prices are increasingly being determined by fundamental factors. This is another sign that the global economy is finally moving away from Financial Crisis mode as the outlook becomes brighter. However, that does not mean there will not be some bumps along the way.
Sovereign bond yields had fallen to historic lows because of the Global Financial Crisis (GFC) and the related collapse in GDP growth and inflation (and threat of deflation) and the plunge in policy interest rates. QE added to the downward pressure on yields. As all of these now reverse, yields will have to react. The latest signs are that they are reluctant to do so, largely because of scepticism over whether the recovery is sustainable. But if growth does continue and inflation returns, then central banks will become less accommodative. If the world is truly getting better, markets will have to reassess where the risk free rate is and what the equilibrium real interest rate should be. The latter was probably negative in the GFC, but is now moving higher again. Rising term premia are an inevitable consequence. Meanwhile, equities are responding more to fundamental influences such as earnings growth – as they have done in the recent upbeat earnings seasons for Q1 and Q2 this year (Figure 2).
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 (Figure 3). Having risen back close to target in several countries, recent releases have shown modest declines in inflation , casting some doubt on the underlying trend. Inflation expectations, which had also recovered, have retreated in a similar manner, suggesting that markets are sceptical about policy makers’ ability to reach inflation objectives (Figure 4). We continue to believe that sustainable, positive inflation is normal and that inflation rates will move back to target in most countries.
Recent increases in inflation have not been confined to developed economies – the trend has been seen in many emerging nations as well, including China, although the challenge that it has in large part been due to moves in energy and commodity prices is a legitimate one. Core CPI measures are still subdued in many areas, including Europe and Japan. 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. Expectations of large-scale fiscal stimulus fade
Budget deficits spiralled higher in the GFC. Subsequently austerity measures restored a degree of fiscal discipline, but the legacy of high public debt is still with us. Despite this, there were hopes that governments around the world might take advantage of low interest rates and embark on expansionary fiscal policy to boost sluggish growth. Such hopes are now fading. In the US, the fiscal arena is just one area where the Trump administration has not delivered anything like the extent of change that had been presented during the campaign. It is still reasonable to assume there will some tax cuts and, perhaps, spending initiatives, but they are likely to take longer to be implemented and be on a smaller scale.
Elsewhere, a fiscal boost is possible in Japan, while in the Eurozone the cyclical upswing has reduced demands (and the need) for fiscal expansion. There is still quite a relaxed approach to deficit limits across the region despite many pushing against or exceeding the 3 per cent deficit limit (Figure 5). If this is adhered to, there is little scope for material fiscal easing overall. The political muddle in the UK suggests a reduced focus on austerity is probable. If growth weakens alarmingly, a fiscal boost should not be ruled out. Finally, China’s fiscal deficit target for 2017 is 3 per cent of GDP, unchanged from last year. While they remain on track to achieve their GDP growth objective of 6.5 per cent, this stance is unlikely to change significantly.
5. Political prioritisation of national over collective interests
With Donald Trump as President of the US, the issue of national as opposed to collective interests is unlikely to slip from the headlines for very long. But the first six months of his reign have suggested that the more extreme versions of his populist agenda will be appreciably diluted. Others are being shelved or 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 a number of political hurdles have been cleared, notably in France, where the Macron government has been elected on a pro-reform agenda.
Key elections follow in Germany and Italy. Anxiety levels regarding nationalist and populist movements have retreated significantly, but they have not disappeared (Figure 6). The better economic backdrop as well as clearer signs of increased harmony between member states, should help prevent narrow-minded nationalism gaining much traction, but there is no room for complacency – in tougher times such worries could swiftly resurface. Finally, although the possibility of a “hard” Brexit may have fallen modestly, the messy election result – as well as the negotiations themselves – has the scope to provide further upsets in the UK and a drift towards greater self-interest.
6. Opportunistic Chinese reform
Policy stimulus in China ensured that growth worries in 2016 were unfounded. The Chinese economy is currently achieving or even exceeding its GDP growth target for 2017 (Figure 7). This has provided an opportunity for the Chinese authorities to take advantage of the benign economic backdrop and address concerns in other areas. In particular they may attempt to tackle excess leverage in key parts of the system and hence prevent the build up of bubbles and other debt-fuelled excesses. The risk is that they miscalculate the degree to which they can reduce leverage and cause a growth undershoot. Should that happen, policy would be swiftly reversed, especially with the key plenum this autumn on the horizon. Stability in the Chinese economy looks assured as long as they can retain control over capital outflows. The opaque nature of Chinese data means that it will be difficult to discern any early warning signs of slowdown.
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 can not 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. Trump may find it easier to push through initiatives in this area as most do not require legislative change. It remains to be seen whether other countries follow this lead. Across Europe there is less interest in a lighter regulatory touch, but there are some signs of a softening of their stance with regard to the final elements of Basel III which are expected to be phased in over the next two years. Lighter regulation could help offset some of the concerns regarding market liquidity.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at 30 June 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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