Global Market Perspective Q1 2018
Themes for 2018, slowing global liquidity, the behaviour of inflation and a review of 2017 all feature in this quarter's economic and asset allocation views.
Risk assets performed well in 2017 as the combination of strong economic growth and low inflation helped drive financial markets. Additional supporting factors were a rally in oil prices and a softer US dollar, which particularly helped the emerging markets to enjoy a year of outperformance.
Enthusiasm for technology also continued to play its part with some of this spilling over into the extraordinary rise of bitcoin.
It was all a far cry from the caution that greeted the start of 2017, when investors were fretting about populist politics. President Trump was about to take office in the US. At the same time, Europe faced a series of national elections, which threatened to reflect the rise in scepticism toward the EU seen in the Brexit vote. In the event, none of the worst case political scenarios played out, markets were able to focus on the synchronised recovery in global growth (see Review of 2017).
That does not mean that politics does not matter. Markets would have performed differently had President Trump started a trade war with China, or Marine Le Pen had become president of France, for example. Indeed, we think political risk could return in 2018. The general election in Italy and ongoing Brexit issues in the UK will be in focus, but the risk is more in the US than Europe in our view. The mid-term elections threaten to return Washington to grid lock unless the president’s approval rating and hence the standing of the Republican party materially improves.
The “return of political risk” is one of our themes for 2018. Another is “goldilocks gives way to reflation” where we see the low inflation-strong growth environment being replaced by a more conventional reflation environment. Growth continues but central banks are likely to be more active. Monetary policy is also set to be a focus in our third theme: “the long farewell to quantitative easing”. The Federal Reserve (Fed) has already started to reduce its balance sheet, while the European Central Bank (ECB) is expected to have finished its asset purchase programme by the end of September this year. Although the Bank of Japan (BoJ) will continue to intervene, overall global liquidity growth is set to slow significantly over the next two years (see Strategy note).
For investors the key question will be to what extent these themes undermine markets through increased risk premia as potentially higher bond yields have a knock-on effect to equity valuations. The behaviour of inflation will be critical; central banks have focused on a slow normalisation of policy, but there is a risk that inflation will force their hands to be more aggressive. The US will be in focus in this respect, but do not rule out a pick up in euro area wage inflation where the Phillips curve seems to be intact (see Research note).
Our asset allocation remains biased toward equities and emerging markets and we are generally short duration in our bond portfolios. We are still focused on the growth improvements which have led the rally in 2017. However, we would expect to fade this through 2018 as our themes play out.
The full Global Market Perspective is available below.