We remain focused on the risks these events pose, and are actively stress testing our portfolios with a variety of scenarios as we did for Brexit. Looking beyond the headline political uncertainties, we are focused on a few key market themes, including a possible inflection point in central bank policy and opportunities for tailored implementation such as emerging market equities ex Asia.
1. Fears of a recession
Markets have been concerned over the possibility of a global recession, but we feel these fears may be overdone and are positioned accordingly since our models do not lead us to expect a global (or US) recession. Instead we anticipate continued lacklustre growth and continued headwinds from the debt deleveraging cycle. At this stage we expect the negative feedback loop from the UK to be constrained by central banks with the global impact on growth and trade likely to be limited, unless there is a contagion effect through euro-zone banks.
2. Rates lower for longer
Interest rate expectations have eased and inflation expectations have fallen again with bond yields now pricing in very low growth and inflation for the long term. Despite the global trend towards lower rates, market expectations of interest rate profiles can overshoot or undershoot, and it is these differences that we focus on when we mange overall duration exposure. One such example is in the US, where our short-term rate hiking profile is less aggressive than that implied by the market.
Figure 1: Fed rate hike expectations vs Investec Asset Management
Sources: Bloomberg and Investec Asset Management, as at October 2016.
The global economy continues to expand at a slow pace, but with fewer signs of an imminent recession. Economic data has been mixed, but is still consistent with a gradual expansion. We would characterise the environment as generally supportive for growth-orientated assets such as equities. Growth assets have also been bolstered by stability in commodity prices, exchange rates and more positive news out of China. We believe this should help earnings to recover and reduce stress in areas which were under particular pressure last year, such as emerging markets.
Where additional easing is required, central banks in Europe and Japan are likely to look beyond current methods of QE and negative rates. In Japan they are now trying to target yields on government bonds which may signal a change in direction. The problems in the European banking sector have been brought into sharp relief by Deutsche Bank, which along with others is struggling to live with low yields in addition to addressing legacy issues and regulatory change.
The forces driving government bond yields ever lower have diminished. Expectations of easier monetary policy, weaker global growth and low inflation have begun to shift to a more mixed outlook. We doubt a definitive inflection point in bond yields has been reached although the chance of looser fiscal policy is constrained by the debt levels of many central banks, and instead expect yields to be volatile.
Asset valuations are mostly reasonable, although fewer areas look very cheap, and credit markets now appear modestly expensive. Ultimately, we believe this environment is best addressed by taking selective exposure across markets, emphasising securities offering sustainable cashflow generation offering a combination of attractive valuations, strong fundamentals and positive sentiment. There are plenty of sources of potential volatility on the horizon, not least the US election and the Italian constitutional referendum, which investors will also have to take account of in their portfolio positioning.
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