Outlook for Investment Markets
Most asset classes have done well. Bond yields have dropped back, despite the Fed tightening US monetary policy, as investors reckon that the strong fiscal stimulus they previously expected from the incoming Trump administration will, at a minimum, be delayed. Equities have benefited from both lower bond yields and from more evidence that the global economy is improving. Looking ahead, bonds will face serious headwinds as the world economy continues to pick up; equities have the potential to make further gains, but on expensive valuations (particularly in the US) they have limited capacity to absorb any unexpected adverse setbacks.
International Fixed Interest — Outlook
It is possible that something has changed in how economies behave, and inflation will remain lower than would normally be expected in a US economy with a low unemployment rate and will also remain low in other economies growing more slowly than the US. It is possible, too, that the tax cuts investors had expected from the Trump administration will continue to be delayed: Recent events have not given much confidence that significant policy programmes can be developed and successfully shepherded through the US Congress. The bond market might continue with its current abnormally low bond yields or even see them drift further back towards their historical low point (less than 1.4% in mid-2016), in which case investors would see ongoing gains from the asset class.
But that does not look like the most plausible outcome. Forecasters are clearly of the opinion that inflation in the US will return to the Fed’s target 2% level or even a bit above: The latest (June) monthly poll of forecasters in the Economist magazine, for example, shows that the consensus pick for American inflation is 2.2% this year and 2.1% in 2018. If so, 10-year US bond yields would need to rise significantly from their current 2.15% to offer a real (that is, above inflation) rate of return, especially on an after tax basis.
A more likely prospect is that we are coming to the end of a very unusual period when yields were pushed temporarily to levels that are unsustainable from any longer-term perspective: Fitch Ratings, for example, estimates there are currently some USD 9 trillion of government bonds that offer negative yields. As a result, prices were driven up to very expensive levels.
It may be a slow and volatile process, but it looks as if this period of ultralow yields is beginning to reverse. The US is clearly in the vanguard with higher rates and an unwinding of bond-buying support, but it is also beginning to happen elsewhere. In June, for example, there was an unexpectedly tight vote (5 to 3) at the Bank of England’s latest policy meeting to keep interest rates unchanged: The minority had wanted to start raising rates now. In the eurozone, the European Central Bank has said that it will not ease any further, although it has yet to get to the point where it will actually start raising rates or cutting back on its bond buying programme. Only in Japan is there is still the prospect of monetary policy being maintained on an ultra-easy setting. In sum, barring some geopolitical or financial shock that might resurrect safe-haven buying, the economic outlook is not favourable to bonds.
International Equities — Outlook
In the past couple of weeks, we have seen two major reports on the outlook for the world economy. They came to much the same conclusion: The immediate cyclical outlook is reasonably good, though not outright strong.
First cab off the rank was the World Bank. Its latest Global Economic Prospects report, while subtitled "A Fragile Recovery," nonetheless expects the world economy to grow by 2.7% this year, a bit faster than the 2.4% achieved in 2016, and to pick up a little more steam in 2018 (growth of 2.9%) and 2019 (again 2.9%). Growth prospects are somewhat lopsided by region, with the developed economies likely to grow by only 1.8% next year compared with the 4.5% expected for the developing and emerging economies (mostly owing to expected 7.5% growth in India and 6.3% growth in China). The "fragility" bit comes from the report’s assessment that “the balance of risks remains tilted to the downside, although slightly less so than at the start of the year.” It said that “Increased protectionism, persistent policy uncertainty, geopolitical risks, or renewed financial market turbulence could derail an incipient recovery.”
The OECD’s latest update of its Economic Outlook was somewhat more upbeat. Its world growth numbers are a bit higher: 3.0% for last year, 3.5% for this year, and 3.6% next year, and like the World Bank it has the developed world growing more slowly this year (2.1%) than the developing world (4.6%, once again with India and China at the forefront). And it can even see the possibility of some positive surprises: “There are upside risks to the projections for investment, trade, and productivity. Evidence from business surveys and from data suggests that the ageing of the capital stock may spur investment in higher-quality capital with more advanced technology,” with assorted positive side effects.
But it, too, worried about much the same set of risks as the World Bank—“Geopolitical shocks and trade protectionism could catalyse snapbacks in asset prices and realise downside risks through a variety of channels”—and the OECD appeared especially concerned about risks from the financial markets, where both bond and equity prices are unusually high. It said that “Big corrections in various asset prices would weigh on economic activity” through a variety of channels.
The latest (June) monthly survey of international fund managers run by Bank of America Merrill Lynch showed that the managers strongly believe global equities are overvalued. A record net 44% of them were of that view (a "net 44%" result being what you get, for example, when 67% subscribe to the expensive view while 33% do not). They saw the US market as especially dear, with a remarkable net 84% (that is, virtually everyone) picking it as the most expensive market in the world; the tech sector in particular was seen as pricey. The fund managers rated investing in the tech-heavy Nasdaq market as currently the most "crowded" investing strategy, where the weight of money herding into the market has most distorted the value on offer.
Despite these views, the fund managers continue to have overweightings in equities, though with pronounced regional variations: heavily underweight in the US and well underweight in the UK, neutral in Japan, and overweight everywhere else, particularly the eurozone (where France and Germany are the top picks) and the emerging markets.
The reason for the overweighting to equities, despite their priciness, is high expectations for global profits growth. If all goes well, for example, along the lines the World Bank expects, then high valuations may well prove justified. But equally, as the BAML commentary said, “Market vulnerability to profit weakness is very high.” The survey asks managers what risks they are most worried about that might derail their optimistic expectations. This time round, the answers were (in descending order) a wheel coming off in China, a crash in global bond markets—the managers believe monetary policy is now too stimulative and interest rates will need to rise, hence the risks to bonds—and prolonged inability to enact US corporate tax reforms (which may be a proxy for a wider concern about US' economic policy direction).
All going well, world equities may continue to grind out further gains, but it is against a background of potential risks that investors continue to undervalue: The VIX index of expected equity volatility in the US, often used as "fear gauge," remains at historically low levels.
Performance periods unless otherwise stated generally refer to periods ended Jun 16, 2017
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