What policy challenges could move markets?
2018 outlook (part 2)
The Bank of England, the European Central Bank and the US Federal Reserve all tightened monetary policy in 2017. Should investors be prepared for more of the same next year?
Emiel: With the US Fed winding down QE (quantitative easing) in 2018, how do you think markets might react?
Chris J: Fixed income markets will have to adjust to the policy priorities and communication style of Jerome Powell as the new chair of the Federal Reserve. Also, considerable turnover on the committee could lead to a fundamentally different perspective on the monetary policy outlook, potentially shaking up asset prices used to the gradualism and transparency of the old regime.
We don't know whether the wind-down of US QE will trigger tensions that destabilise markets. Money market spreads (ie. the difference between the cost of unsecured bank borrowing and overnight interest rates) and the slightly esoteric cross-currency basis (ie. the difference between onshore interest rate differentials and the cost of hedging currency risk) are the canaries in the coal mine that could indicate the risks of a sharp rise in the value of the dollar.
We continue to see a low interest rate environment for 2018. Sure, interest rates can drift up, which is priced in the forward curves as well, but we do not think this is the beginning of the end for the bond markets. There are too many structural factors holding down interest rates including an ageing society and the heavy burden of debt.
Willem: The Japanese yen exchange rate is interesting in this context; the US dollar/Japanese yen exchange rate may go up the stairs (so a weaker yen) amid slowly rising global yields, but down the elevator in many other scenarios, including a small probability of a ‘hawkish pivot’ by the Bank of Japan. This makes the yen interesting within a portfolio context, as it could appreciate just when you need it the most.
Emiel: I agree the yen is an interesting currency to consider for a long position. During my November visit I met with a very senior official at the Bank of Japan. He talked at length about the possibility and condition for a hawkish adjustment of their monetary policy. This could strengthen the yen and be good news for Japanese bank stocks. Moreover, the yen is a very attractive diversifier for investors who own equity risk, as the two are negatively correlated.
Hetal – what’s the picture in Europe?
Hetal: Well the lack of inflation means that the impact on the real economy will have to be monitored carefully. We have sympathy with concerns that the policy normalisation is largely as a result of self-imposed constraints and bond scarcity, and therefore it could be a policy mistake.
On the other hand, in the UK, the continued pass-through of the weaker pound and the recent pick up in the oil price should keep inflation above the Banks of England’s target, making another rate hike likely in 2018. Although Brexit uncertainty and a slowing housing market will likely prevent them from going much faster, particularly while wage growth doesn’t pick up.
Emiel: Just recently the news on the Brexit negotiations between the EU and UK government has improved considerably making a deal more likely. Any further progress could nudge the EU to speed up approval for a two-year transition deal, which will effectively delay Brexit until 2021. This will give more time to negotiate a trade deal and it will give governments and business extra time to prepare. This boosted the performance of three UK trades we like: long sterling, short gilts and short UK inflation. We continue to like these positions going into 2018.
So Tim how should we capture these policy changes in our portfolio risk management?
Tim A: Realised volatility of multi-asset portfolios is very low. Firstly we see low volatility in individual asset classes and secondly we see low correlations between asset classes. This might lure investors into a false sense of security as the observable risk of multi-asset portfolios is going down.
However, we continue to stress test our portfolios for adverse scenarios; one of them is particularly bad for multi-asset investors: when equities and bonds go down at the same time. This could be caused by central banks tightening monetary policy faster to fend off rising inflation, as inflation can simultaneously drag equity and bond prices lower.
Emiel: I agree, that keeps me awake at night. In this light I like portfolios that are long equities but hedge the risk with being long inflation and the US dollar. This should offer some protection if interest rates rise (which is a risk but not our base case). In my view this is an interesting example of seeking to create some attractive optionality in the portfolio with reasonable upside and limited downside.
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