“In reviewing the performance of global markets so far this year, we find that equities have been the best performing asset class,” says Keith Wade, Chief Economist and Strategist at Schroders. “Gold and corporate bonds have also done well, but commodities were the worst performers.”
Wade raises the question of whether rising equity markets and low volatility has resulted in investors becoming complacent, especially against a backdrop of falling bond yields and elevated political uncertainty.
Mid-year markets review
2017 has been an interesting year for investors so far – US President Trump’s promises of tax cuts, infrastructure spending and deregulation drove the “Trump reflation trade” at the end of 2016. “Although it continued into early 2017, investors have lost some faith in the president’s ability to deliver on his promises and the rally has faded in recent months,” says Wade.
According to Wade, equities have been the best asset class to be invested in so far this year. “Commodities have been the worst with oil having re-entered bear market territory (despite OPEC production cuts), although gold has been relatively resilient,” he says. “Among equities, Europe and emerging markets were the leading performers, helped by better risk sentiment and a softer US dollar (which has been one of the weakest currencies this year so far).”
“In the fixed income world, the best performance within government bond markets came from UK gilts as a slowing economy and Brexit uncertainty made the safe haven asset more attractive,” continues Wade. “US Treasuries also performed well, although most of this was as a result of the unwinding of the “Trump trade”. As for credit markets, US markets outperformed their European peers comfortably, against a backdrop of falling bond yields but rising equity markets.”
Amongst currencies, the euro and yen have both performed well on a trade-weighted basis, while the US dollar has depreciated. Most other currencies have remained stable.
Are current trends sustainable?
According to Wade, the fall in government bond yields alongside the ongoing rally in equities suggests investors are split on the current outlook. Volatility remains very low despite the Federal Reserve’s (Fed) tightening policy. He says that while liquidity is ample and has in the past been a major factor in causing these markets to move in the same direction and suppressing volatility, history suggests that this trend is unsustainable.
The fall in oil prices, believes Wade, is a possible factor for the current state of markets. “Although lower oil prices will hit the energy sector, with lower inflation ahead, some central banks like the Fed and Bank of England may become less ambitious in tightening monetary policy, while some, such as the European Central Bank (ECB), may be forced to step up stimulus again,” he says. This suggests risk assets could continue to do well, especially as growth continues unabated, while inflation remains low.
Are investors complacent?
The strength of equities against a backdrop of falling bond yields and elevated political uncertainty has raised the question as to whether investors are becoming complacent. Wade believes that their complacency is evidenced by the new lows seen in the Chicago Board Options Exchange (CBOE) Volatility Index, often referred to as the “fear gauge”.
“It could be argued that volatility is low because investors are now comfortable with the three primary factors that have driven volatility in recent years. Specifically, concerns about the Fed tightening monetary policy, China’s currency policy and the oil price have all eased. We would add that the current low level of volatility today also owes something to favourable political outcomes in Europe where there has been no swing toward populism,” says Wade.
Threats to low volatility
That said, the next shock to markets may not be driven by the Fed, oil or China. Wade believes that it could be geopolitical in origin, for while political risks may have eased in Europe, they are building in Asia. “Notwithstanding such an outcome, of the three main drivers discussed, Chinese currency policy seems to be less of a concern although the oil price risks falling further,” says Wade.
Wade sees the greatest worry as US interest rates where the market appears to be underestimating the potential for higher rates. “The desire to normalise remains high and rates are still well below where most models would have them given where the US is in its economic cycle. At present the market is only discounting one, or possibly two, more rate hikes to the end of 2018. Meanwhile, the Federal Open Market Committee (FOMC) members put rates at just over 2% at the end of 2018,” says Wade.
Complacency may be hard to resist
According to Wade, such pressures will not become apparent until further out. Low inflation will keep the Fed cautious and the start of balance sheet reduction will probably see the Fed pause rate rises for six months to monitor any more general tightening of financial conditions.
“Unless the Fed signals otherwise, the difference of opinion between the market and the FOMC may not be resolved until spring next year. Meanwhile, central bank asset purchases are likely to continue to expand,” says Wade.
Wade concludes that in this environment investors may find it hard to resist being “complacent” as liquidity will continue to drive markets with the risk that they move into bubble territory.