Where are we in the interest rate cycle?
We are now entering a new regime of tighter liquidity both in terms of rising rates and reducing central bank balance sheets.
The US Federal Reserve has raised rates now three times since the end of 2016 and we expect a further raise this year.
If the current weakness in US inflation proves transitory, as the FOMC expects, we expect them to continue to gradually tighten policy through 2018 through interest rates increases and balance sheet reductions.
We highlighted previously how the European Central Bank (ECB) was going to find it increasingly difficult to maintain its aggressive monetary stimulus and they, alongside other central banks, confirmed a willingness to start reducing the scale of their policy easing, reflecting improved economic fundamentals as well as concerns over stability if financial conditions remains loose.
The ability of central banks to smoothly exit quantitative easing remains uncertain, however, given that there is really no precedent to guide them in terms of how to safely shrink balance sheets in economies that have become dependent on easy money.
Which currencies can outperform against the US dollar?
The euro’s recent rally looks to have gone too far, too fast as sentiment has swung from relative pessimism to optimism against the US in terms of policy, politics and growth.
Other currencies perhaps have greater scope to outperform the dollar in the near-term. In particular, we like a number of commodity linked currencies where policy looks too loose, notably the Canadian dollar and the Norwegian krone.
The Swedish krone also has room to perform given a strong recovery and building inflation pressures.
We also see potential in a number of emerging currencies, where real yields are high, balance of payments positions have moved back into surplus and they have lagged the recovery in the euro and commodity prices.
Among more defensive currencies, the yen looks an attractive hedge against any further disappointment in inflation or lack of policy follow through by the central banks of other major economies.
Are equity markets shaping up?
In general, we expect equities to continue to make gains, helped by continued economic growth, which should further boost earnings, and by still accommodative monetary policy.
Valuations are becoming less compelling and investors are a little complacent so we wouldn’t rule out a correction before the bull market resumes.
Although US equity valuations are relatively stretched, earnings continue to improve meaningfully and help justify these levels, and they offer high quality more broadly.
European equity fundamentals are continuing to improve with strong sales growth and a generally more supportive macroeconomic backdrop.
Supported by strong economic data, Japanese equities continue to appear attractive and fundamentally there are strong stock buyback trends providing attractive opportunities at the company level.
Valuations of Asia ex Japan equities still look relatively attractive, albeit to a lesser extent than from last year. In China, we are positive on companies that stand to benefit from the country’s reforms, economic rebalancing and supportive valuation.
Continued growth or slowdown?
The global economy has decent momentum and the risk of a recession over the next year still appears to be low, although a slowdown to trend seems likely. The key uncertainties in developed markets are around policy.
In the US, the evolution of inflation and fiscal policy will be key to how much monetary policy is tightened, whether bond yields rise materially and the dollar can recover. These developments would likely be significant for markets and global growth in 2018.
The Chinese economy remains an important driver for emerging market economies and here the data is holding up fairly well so far despite targeted policy tightening, and our ‘nowcast’ models anticipate only very modest slowing of growth, but the risk from excessive policy tightening can’t be completely dismissed.
A number of other Asian economies are at the peak of their financial cycles, but we expect their currency markets to bear the brunt of any adjustment process that will be necessary.
John Stopford is head of multi-asset income at Investec Asset Management.
