How to identify the future political and monetary policy events that will dominate market discussions is critical. It is our job to filter out noise and determine what signposts, events or issues are truly meaningful in terms of their potential impact on markets.
This feels particularly pertinent at present, when the broad global macroeconomic environment can be characterised as ‘Goldilocks like’, with decent global growth and only gentle rises in inflation. The global economic setting is not sufficiently hot to warrant aggressive monetary tightening, nor so cold as to create fears of economic recession. It is important to know what might upset this.
For now we anticipate that these conditions will persist. Better nominal growth is being reflected in corporate earnings expectations, which, in marked contrast to the recent past have not suffered from a strong ‘gravitational pull’ lower, but have instead held up and are growing. Equity valuations are full but supported by the growth outlook and a positive earnings cycle.
In Europe and the UK, fixed income markets have moved away from pricing in disinflation. Credit spreads are seen to adequately compensate for underlying corporate default risk, in Europe and the US at least. But companies are venturing increasingly into typically bond unfriendly activity, such as M&A, so the outlook for credit is perhaps more muted than it was.
So what are the events that could upset the apple cart? From a monetary perspective, meaningful global issues include: developments in the neutral rate, quantitative tightening in the US, Eurozone interest rates, and a European Central Bank taper. From a political perspective, we have highlighted: a China trade war; North Korea; renegotiation of NAFTA (the North American Free Trade Agreement); the future health of Middle East economies; and fiscal and monetary sustainability in the Middle East.
China’s ‘impossible trinity’ or trilemma has also been under our microscope. The trilemma economic concept states that a country can only have two of the following three at the same time: a controlled exchange rate; free capital movement; and an independent monetary policy. China, to some extent, has been pursuing all three policy objectives simultaneously in recent years, and we fear that a disorderly unwind of the trilemma might occur if this persists. For example, if 2% of banking assets were to leak from China’s capital account, by 2020-22 that could wipe out nearly half of China’s foreign exchange reserves.
There are clear flashpoints for the trilemma to come to the fore in China over the next five years, but we do not believe this is a near-term risk. For now, growth in China remains steady at a slower and more sustainable pace and, as with other countries, a rise in economic productivity would allow it to move up the productivity frontier, avoiding a bad financial outcome.
On the currency front, we have downgraded our strategic view on the US dollar from neutral to negative; while sterling has moved from dislike to neutral, leaving the euro as our currency of choice. Both moves reflect developments in rates markets, particularly at the short end, as well as a broader risk appetite.
Elsewhere, Japan has been occupying our thoughts. We have favoured Japanese equities since March 2013, a period associated with strong absolute and relative returns from the asset class. Yet in some ways, this has ‘worked for the wrong reasons’ because over this period Japanese equities have cheapened rather than re-rated against the rest of the world. With political uncertainty creeping higher in the run up to the forthcoming snap election, and potentially serious implications for Japanese equities should Abenomics come under threat, it is important to monitor the region. We have decided to maintain our favourable stance. Corporate governance is improving and companies have the means to drastically improve shareholder returns if they choose. We believe the LDP will win the forthcoming election, although this might be with a reduced majority. Even so, we see Abe’s popularity coming back into focus in 2018. We also expect Bank of Japan governor Kuroda to remain at the central bank, providing continuity albeit with a more hawkish fiscal tilt.
Toby Nangle - Global Co-Head of Asset Allocation, Head of Multi-Asset, EMEA - Columbia Threadneedle Investments
Maya Bhandari - Portfolio Manager, Multi-Asset - Columbia Threadneedle Investments