Global macro indicators are currently strong with a cyclical recovery underway in most regions. In particular, industrial and consumer survey data in the US has been very positive. Growth and inflation data in developed (DM) and emerging markets (EM) has beaten analyst estimates by the greatest margin in several years. We are mindful that expectations are high for a continuation of this economic strength which is currently helping to underpin risk assets.
We have a more balanced view for this year’s outlook. We expect increased volatility to materialise due to the recognition that we face an unusually high uncertainty of outcomes - both positive and negative. A key focus for us, as to what will tilt the balance of outcomes, is how the new US administration prioritises its pro-growth versus its protectionist agenda and whether European political risks materialise.
A pick-up in global growth combined with higher infrastructure spending, Trump policy prospects, higher commodity prices and sharp producer price inflation rebounds are causing higher inflation expectations across developed and emerging markets. The key questions are:
i) How much further can expectations rise?
ii) What will be the extent of the realised inflation outcomes after the very strong positive commodity base effects that peak in Q1?
While global leverage levels on one hand restrict potential inflation outcomes, we are also sensitive to the fact that protectionism will lead to higher prices in the medium-term. In the long run, ageing demographics tend to be associated with higher inflation rates, while commodity prices are likely to continue to remain supported. The market seems to be discounting no persistent increase in inflation as shown by the fact that the US breakeven curve is now inverted.
The secular trend of unwinding globalisation has been underway since 2014 (as measured by the number of protectionist measures, trade agreements and tariffs) but is set to accelerate with Trump and Brexit. Among the implications of increased protectionism are higher cost push inflation, increased currency volatility and reduced trade, albeit from a heavily impaired base. Protectionism goes hand in hand with rising nationalism, which challenges the current geopolitical world order, with an inward-looking US further cementing this nationalistic trend. We think that going forward the global markets justify an elevated geopolitical risk premium. In this context, we also have an elevated political risk calendar in Europe which could lead to a further repricing of a euro break-up risk. As we have demonstrated with other major events, we will keep the powder dry to take advantage of dislocations in global markets and are focused on risk-adjusted returns.
In the US, the very pro-business administration is growth positive with several appointments coming from the private sector. There is also a de-regulation agenda for the financial and energy sectors. Alongside the potential for corporate tax cuts, this business friendly environment could lead to capital coming back to the US and a capital expenditure revival that would be positive for productivity and potential growth. The recent pick up (overheating) in US survey (i.e. soft) data is notable. As growth expectations start getting very elevated we need to question how much of this will translate into hard data? There are risk factors that we are watching in this respect – some linked to policies, some linked to the broader cycle. On the policy side outcomes, protectionism is a risk. The fiscal, tax and deregulation policies, their timing and/or their effective multiplier upon implementation could come short of expectations. The Border Adjustment Tax (BAT) is a new policy proposal which has positive and negative impacts for certain parts of the economy depending on how it is implemented, and of course, the extent to which other balancing factors such as the US dollar adjust. Of the risk factors linked to the broader cycle, we note that the length of the US recovery is very long by historical standards (93 months and 3rd highest in history). Trump starts his presidency with the highest debt/GDP ratio of any US president in history aside from President Truman in the 1950s. Higher interest rates, and more importantly higher long rates, matter given the long-dated and fixed nature of the US mortgage system while a strong US dollar is a drag for exports.
In Emerging Markets, value opened up following the Trump win as the market adopted a "cherry picking" approach for the Trump agenda. EM risk premia rose on protectionism fears yet EM will be the beneficiary if higher growth were to materialise, especially commodity exporters. Some major EM countries are now recovering from deep recessions and political risk is abating. EM external vulnerability is significantly reduced today versus the “taper tantrum” of 2013, while valuations are more attractive. We are most constructive on countries with high real rates both on an absolute basis and as a spread to US real rates.
Going forward we expect that the reduced incremental effectiveness of quantitative easing programmes (QE) and an increasing list of counter-productive effects will shift investors' focus away from their reliance on excessive monetary easing. Central Banks’ (CB) unconventional policies have significantly reduced volatility and induced herding behaviours. As such, passive strategies strongly outperformed active strategies in this cycle. We expect that as we turn the QE page, our active strategies, driven by a thorough and intense research-driven investment process, will perform strongly. Importantly, during the QE cycle, asset prices lost their previously very strong correlation to macro data and economic surprises - a result of the perception that CBs can “underwrite” the economic and capital market cycles and therefore “good news is good news” and “bad news is good news” too.
A number of significant distortions appeared as a result of CBs’ outsized buying, especially in certain pockets of fixed income. This resulted in the crowding out of private investors, leading to poor price discovery dynamics. Some of these markets are under a re-adjustment phase at the moment and re-opening to private capital – but only at the right price. Risk premium is now finally also returning back into safe haven fixed income. As extraordinary monetary accommodation is getting pulled, we expect that risk assets will recoup their previously strong correlation with economic cycles and this is crucial for active investors as it will create more opportunities for alpha generation.
Summary of our asset class views: