Higher potential inflation and increasingly divergent economic growth to set complex, positive backdrop for active investors
- Multi-speed growth and widening regional economic divergence
- More expansionary fiscal policies expected in the US, Europe and Japan
- “Trump factor” to negatively impact outlook for China and Emerging Markets
- Opportunities for active investors with a risk-aware mind set abound
The firm projects that investors will find themselves navigating a markedly different environment, in terms of both economic and financial markets, in 2017.
“As the incremental benefits of extraordinary monetary policy fade, and the schism between the political establishment and the electorate widens in more countries, a new economic and political framework is going to take to the stage in the new year,” commented Monica Defend, Head of Global Asset Allocation research at Pioneer Investments. “We are likely to see multi speed growth with widening regional economic divergence and inflation moving modestly higher, particularly in Developed Markets (DM).”
The low growth/low inflation scenario that has characterized the last few years is set to give way to a more scattered and economically heterogeneous phase. In our view, more expansionary fiscal policies enacted mainly through tax cuts will be the primary approach chosen by governments to address social discontent, while also trying to stimulate growth and inflation and reduce future debt burden. European governments will likely be forced to proceed in this direction, towards a more benign fiscal policy and more pro-growth initiatives to deal with the ongoing challenges of a weak growth, lowflation and the rising risk of political instability. Germany, which, relatively speaking, has ample fiscal flexibility, could come enact expansionary fiscal policies ahead the 2017 elections (for now, only a very mild tax reduction has been mooted). Expansionary fiscal measures are also expected in Japan to lift its anemic growth. While this might be a winning strategy in the short term, we doubt these measures will address the need for increased productivity and more “quality” growth in the medium term.
We believe that upcoming changes to global trade arrangements – precipitated by the election of Donald Trump – are going to be key. If the most extreme aspects of Trump’s protectionist campaign assertions are reined in, his pledged substantial infrastructure spending and promised tax reforms could provide a one-off boost to US growth and inflation. Under the reasonable assumptions of a moderate “Trump factor” and a more benign commodity cycle, China and Emerging Markets (EM) will, in our view, proceed or even accelerate in the transition of their economic model towards more domestically-driven quality growth with the US playing a somewhat diminished role. Over the coming year, their outlook will be highly sensitive to news flow from the US (USD and rates in particular), in our opinion. We do acknowledge, however, that they are less vulnerable today than they were in years past and are better equipped, in terms of reserves and fundamentals, to deal with the new economic challenges. Here, again, the winners will be those with more fiscal and monetary capacity and further commitment towards structural reform. Asia, in this regard, continues to be our most favored area.
In the context of this new dynamic scenario, there are several themes that investors with an active and risk aware mind-set could pursue:
- Reflation trends make a flexible and unconstrained approach to fixed income paramount. We believe that the Trump effect will favour reflation trades that can be played across a broad spectrum of fixed income investment strategies around the world. Within the theme of reflation, we like inflation-linked bonds in the US and in Euroland, where we believe that they still price in a very low inflation pattern. We believe that the US Treasury curve will continue to steepen on improving macro fundamentals, as we are potentially entering a new regime of expansionary fiscal policy. Assuming that the path of Fed hikes stays relatively slow, US corporate earnings are likely to improve in this environment and defaults are probably going to normalize, after the energy sector-related spike in 2016. In this environment, corporate debt will probably outperform sovereign debt in both Europe and the US, even though the asset class’ total return may be limited compared to 2016. Loans and other floating rate strategies could be compelling opportunities.
- Profiting from potentially stronger growth via equities. Global, US and Asian equities may benefit the most from a broad reflation environment and national initiatives, where earnings growth should see better support. This will be less so in Euroland, where growth perspectives are more moderate and political and headline risk remains high. We also favour Japanese equities, as Japan is now the centre of pro-growth and reflationary experiments and the internal political turbulence appears to be more contained. Premier Abe’s efforts to combine monetary policy with fiscal expansion and a strong dollar all support positive momentum for Japan, as does the potentially more dominant role for Japan in Asia, should the US becomes more domestically-oriented.
- The search for income continues, but will require an increasingly selective approach. There are still pockets of value left in European and US credit, however the margin for carry is now slimmer than a year ago. EM can play a role in the search for income, but with a more careful approach paying close attention to the evolution post US election. We also believe it will be important to broaden the sources of income by incorporating multi-asset approaches, fixed income (especially flexible, unconstrained, higher yielding) and equities, while also focusing on security selection and emphasizing quality.
- Currencies: strong dollar, tactical opportunities. We think that the USD will stay supported on the back of the Fed’s interest rate normalisation process and the current phase of asynchrony of central bank policies, which could be exacerbated should the “Trump effect” spur economic growth and inflation. Opportunities could also come from volatility in EM currencies. In general, we see currencies being an important lever for tactical asset allocation and a key value-add through active portfolio management.
- Hedging, protection strategies and diversification to deal with geopolitical risks. Even though we expect slightly stronger economic growth in 2017, we continue to see a number of structural risks on the radar, such as the risk of policy mistakes, the high debt exposure of global economies and geopolitical risks, especially in Europe where the political calendar in 2017 will be very crowded. In this environment, we believe that broadening the source of diversification and incorporating efficient protection and hedging strategies in diversified portfolios will continue to be extremely important to try to protect investors’ assets. In this regard, gold could help smooth potential spikes in volatility as well as real assets more generally which may offer inflation protection and have a generally lower correlation with traditional asset classes that may help during phases of market stress.