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  • Sustained improvement in global growth and slowly rising inflation signal a turn in monetary policy
  • Low volatility regime to persist, lower cross-asset correlation first step of market normalization
  • Duration is going to be challenged; Eurozone equities and emerging market local currency debt preferred assets

More hawkish tone from central banks

As the global expansion has become more broadly established and accepted, central banks have started to sound slightly more hawkish. The fundamental picture has indeed improved and we expect 3.5% global GDP growth this year. Inflation has also been slowly rising. The example of Eurozone is striking, now growing above potential, with deflation fears gone and the ECB openly talking about exit strategy through further tapering and ultimately rate hikes. One area of monetary policy we think is important is balance sheet management. Major central banks are now running a staggering $14 trillion balance sheet (Figure 1). If the US Federal Reserve starts balance sheet reduction next quarter as we believe, the market should acknowledge that a major turning point in global monetary policy has been reached. It is worth noting that these developments are more synchronized than a few quarters ago, both in terms of fundamentals and monetary policy evolution. There will be different starting points and pace of change, but crucially the direction is now the same.

Financial stability affecting central bank policy too

We continue to expect one more rate hike from the Federal Reserve this year as well as very gradual balance sheet reduction starting in the third quarter of this year. We think the Bank of Japan will remain on hold while the ECB is moving towards the exit, expected to announce further tapering this year and deliver rate hikes next (Figure 2). We also note that monetary policy hawkishness is not always driven by inflation as we see in Australia or Canada where financial stability concerns seem to take the lead. Even at the Bank of England, and against the Brexit backdrop, some are stressing the longer-term risks of keeping policy too loose and are arguing for higher interest rates now. 

Markets are slowly integrating the idea of normalization

The volatility regime remains suppressed across asset classes (Figure 3). However, it seems likely that volatility will remain muted during the rest of the year provided that our central scenario prevails. Part of the market normalization theme is that tail risk events do not always trigger a correlated market response. It seems more feasible that volatility may appear in rates markets rather than equity markets because of this and given the upside risks that we see to the Federal Reserve reaction function which isn’t fully appreciated by the market.

While market operators are focusing on the low volatility regime, we prefer to look at the correlation matrix. Significant changes are happening on this front. We highlighted in previous quarters the collapse in global cross asset correlations. We continue to look at the rise in return dispersion as a key part of the ongoing market normalization process. While the equity to bond correlation has moved sharply lower, we also see signs of changing correlations within equities. One key example is the correlation of emerging market to developed market equities which has moved significantly (Figure 4).

Fundamentals matter again

Looking forward, investors will have to pay much more attention to fundamentals as the impact of central bank stimulus fades. While it remains to be seen how individual central banks handle the process, it seems likely the majority – at least initially – will wish to remove monetary stimulus in a gradual fashion. This environment argues for retaining significant equity exposure. As fundamentals matter again, rising dispersion (i.e. lower correlations) also mean that asset allocation matters more than in the past in terms of alpha generation.

Higher term premia and steeper curves

Upward pressure on government bond yields from the improving macroeconomic backdrop will be further supported by the continuing withdrawal of purchases of such assets by central banks. Our central scenario points to higher term premia and steeper yield curves. European core sovereign bonds and Japanese bonds look the most expensive and we maintain our strong underweight position. We keep duration exposure in US Treasuries to balance our aggressive positioning in equities. Should the volatility regime grind higher, rates volatility is likely to rise before equity volatility.

Corporate bonds may find it difficult to avoid the fallout from higher government bond yields, especially if volatility were to pick up in fixed income markets as global QE is withdrawn. Higher volatility is often accompanied by wider credit spreads. However, there are reasons to believe that spreads will not widen significantly and could even narrow because of supportive fundamental and technical factors. Supply looks set to shrink as the financial engineering of recent years begins to unwind (e.g. debt issuance to finance share buybacks). Meanwhile, faster economic growth should boost profits, in turn leading to a general strengthening of balance sheets and reduced default rates.

It is quite striking to look at the implied correlation within European Credit versus the correlation within the European equity market. The former exhibits very low dispersion (i.e. high correlation) which might be a consequence of ECB QE (Figure 5). EM debt in local currency continues to look attractive and is preferred to hard currency EM bonds on valuation grounds. Gradual tightening from the Federal Reserve should not be a headwind as this is compensated by domestic improvements in EM. We continue to expect that while China could push the reform agenda opportunistically, growth will remain in line within the 3-year objective of 6.5%. A China hard landing remains the key downside risk for the asset class, as is an aggressive Federal Reserve hiking much faster than expected.

Equities look more attractive than most sovereign bonds

While it seems certain bonds are going to struggle, equities could do better than many expect as QE is unwound. It looks as if the "Great Rotation" may at long last be about to get under way. Although history suggests that equities tend to suffer once interest rates rise above 4%, rates are currently so low that tighter monetary policy appears to present little threat. For the time being, the likely improvement in economic fundamentals should outweigh the impact of higher interest rates, leading to a growing number of investors switching out of bonds and into equities.

We upgrade Eurozone equities to maximum overweight given the earnings outlook, strength in the underlying economy and renewed political momentum in the Eurozone. We are also overweight EM equities as we still find valuations very attractive and the central scenario of a gradual tightening from the Federal Reserve to be benign for the asset class given its sensitivity to global growth. The first quarter earnings season has globally been very strong, suggesting that the improvement in the economy is real and lasting. Also, the upside risk of European convergence following the French election could lead to higher potential growth going forward. UK equities remain an underweight, as is sterling given the uncertainty of Brexit. Within sectors, we would expect growth and cyclical stocks to outperform income, reversing the trend of recent years. For example, we would expect financials to outperform broad equity markets, supported by rising yields (Figure 6).

The global monetary experiment of the last decade is coming to an end. Whereas in recent years it has been sufficient to focus on liquidity and technical factors, going forward it seems fundamentals will reassert themselves as we gear to market normalization.

Gearing to the new normal

The ‘risk-on, risk-off’ approach that was dominant in the highly-correlated world of recent years is unlikely to prove as profitable in the future as the correlations between and within asset classes break down. Nevertheless, there should still be plenty of opportunities for investors who correctly assess fundamental factors, rather than merely rely on the actions of central banks.

Our asset allocation view

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