Many equity markets have already seen double-digit returns this year whilst volatility, both implied and realised, has declined to very low levels in all asset classes bar commodities. One expected trend that has not emerged is US fiscal stimulus as optimism about Trump’s policies diminishes.
Equity markets, however, keep grinding upwards despite already high valuations and a rollover in macroeconomic surprises. Meanwhile, global bond yields have been in a tight range even with the Federal Reserve (Fed) hiking and announcing a balance sheet run-off. The contrarian view would be to sell equities yet we remain overweight equities and underweight government bonds. Improving corporate earnings and favourable valuations relative to bonds help underpin stock markets. We feel the low volatility environment reflects supportive financial conditions, stronger global growth and lower political risk.
Political risks becoming more balanced
Global political risks are much lower, for the first time in more than a year. US trade policy has been stable and Trump hasn’t been impeached. The second round of the French Presidential elections ended with a decisive victory for Emmanuel Macron By contrast, Theresa May’s party saw its apparently unassailable lead in the UK general election dwindle, eventually losing its majority. Weakened and divided, the government now faces the difficult process of negotiating Brexit. By contrast Italian political risk has receded with the Five Star movement losing ground.
US inflation reverses trend – for now
Our previously-held view that US inflation was on a rising trend has been challenged. The uptick in inflation had pointed to a softer dollar, less Fed tightening and a more pro risk environment. The soft patch in inflation surprised us and, while we expect the uptrend to be resumed later in the year, there is no obvious reason why this should materialise before the end of the summer. Japan has also seen weaker-than-expected inflation and this should be ‘risk’ positive as it allows the central banks to remove accommodation even more slowly. Apart from those that have suffered major currency weakness (e.g. the UK), moderate or high core inflation is almost entirely absent in the world economy. However, the risk that inflation will fall dramatically seems low given low unemployment rates.
Central banks turning more hawkish
Central banks have mostly stuck to the dovish side in recent years when confronted with mixed data on growth and inflation, or political uncertainties. Recent communications from a number of central banks suggest this attitude may be changing amidst the dichotomy between softer inflation, lower yields and falling oil prices versus stronger global growth and financial conditions. As expected, the Fed increased rates in June and announced guidance for balance sheet shrinkage. Minutes of the most recent Bank of England meeting showed that three members voted for a rate rise despite the uncertain political outlook. Several officials from the Bank of Canada have also indicated towards tightening. Given the change in central bank attitudes and rhetoric, the risks of additional rate hikes are rising despite the weak inflation figures.
Team Multi-Asset – BMO Global Asset Management