In the eurozone, outright interest-rate increases still look to be some considerable time away–possibly not until 2019–but speculation ahead of the European Central Bank’s next policy meeting on 26 Oct has suggested that the ECB may soon announce it will scale back the amount of bonds it has been buying in an effort to keep bond yields very low.

The story is the same in the UK. The most recent (October) Bloomberg survey of UK economists, for example, found that three fourths of them think there will be a 0.25% increase in the UK policy rate at the Bank of England’s next policy meeting on 2 Nov, but that rates will then stay on hold all the way out to 2019, when they expect two more 0.25% increases. Among major markets, only in Japan is monetary policy expected to remain at its current full-on supportive setting.

This all makes for an uncomfortable outlook for bonds, and it is not surprising that in the latest (October) Bank of America Merrill Lynch survey of fund managers, 85% thought bonds were overvalued, 82% expected yields to rise during the next year, and a net 61% are underweight in bonds. It was also not surprising that the risk fund managers were most worried about was a policy mistake by the Fed or the ECB as they set out on the difficult exercise of unwinding their post-crisis programmes of monetary stimulus.

The fund managers were also concerned about the previous lemming like rush into outstanding niches of yield in a low-interest-rate world. The BAML survey asks them what they think are the “most crowded trades.” The single most crowded trade was technology shares, but the second was US and eurozone corporate bonds, where credit premiums have been driven down to unsupportable levels.

At the start of this year, for example, the yield on eurozone high-yield debt was 3.33%, when the yield on the 10-year German government bond was 0.17%: investors were being paid a credit premium of 3.16% a year to hold low rather than high quality. Currently the low-quality yield has dropped to 2.17% while the high quality yield has risen to 0.46%, meaning that the credit premium has almost halved, to 1.71%.

As noted later, investors are currently not paying a great deal of mind to potential risks (economic or geopolitical), and there is a case to be made that holding an appropriate allocation of bonds still acts as a useful insurance policy against risks that others appear to be underestimating. But that is as far as the good news extends: The economic fundamentals are currently lined up against bonds, in particular against niches (such as lower-quality corporate bonds) where value is most stretched.

International Equities — Outlook

The global macroeconomic outlook remains supportive for equity performance. The latest (October) forecasts from the IMF, for example, say that “The pickup in growth...is strengthening. The global growth forecast for 2017 and 2018–3.6% and 3.7%, respectively–is 0.1 percentage point higher in both years than in [earlier] forecasts.

Notable pickups in investment, trade, and industrial production, coupled with strengthening business and consumer confidence, are supporting the recovery. With growth outcomes in the first half of 2017 generally stronger than expected, upward revisions to growth are broad based, including for the euro area, Japan, China, emerging Europe, and Russia. These more than offset downward revisions for the US, UK, and India.”

Another potentially positive element is the prospect of tax cuts in the US. Equity markets had risen strongly after President Trump’s election last year on expectations of a strong fiscal boost–what has been called “the Trump trade” or “the reflation trade”–but had been subsequently disappointed by political dysfunction, which had prevented tax policy changes. At time of writing, however, the Senate's passage of a budget bill on 19 Oct appears to have made passage of a tax reform bill substantially more likely, and a reinvigorated Trump trade appears to be one element in the recent strong run for global equities.

Fund managers are also increasingly of the view that the global economy is firming. In the latest (October) fund manager survey by BAML, the proportion expecting good times ahead (“above-trend growth and below-trend inflation”) exceeded the proportion expecting ho-hum times (“below-trend growth and below-trend inflation”) for the first time since 2011. As a result, a net 45% of fund managers are now overweight in equities, the highest level in six months.

But there are still two significant challenges to further strong equity performance. The first is valuations, which are high by historical standards, especially in the US. Fund managers at BAML have responded with overweightings in other parts of the world, particularly the eurozone, where a net 58% of managers were overweight in October, but also emerging markets (net 41%) and Japan (net 23%). They have stayed underweight in the US (net 21%) and, because of Brexit risks, in the UK (net 31%).

The second challenge is underappreciated risk. The fund managers can see potential upsets down the track–their top three were monetary policy mistakes by the Fed or ECB, North Korea, and a bond market crash–and so can the IMF. Its list also included monetary policy missteps but added other financial sector stresses (for example, the fragile state of some eurozone banks), protectionism, deflation, and geopolitical risks.

The fund managers were taking some modest steps to recognise the risks: They are on balance overweight in cash, but the actual cash level in the average portfolio (4.7%) is not especially high. Other measures, however, suggest that investors as a whole appear to be paying little mind to any of these risks materialising: Measures such as the VIX index of expected volatility in US share prices, for example, continue to track at levels consistent with totally unruffled investors.

Cautiously successful normalisation of monetary policy and an improving economic outlook still look like the most probable scenario, and equities should make further gains if it comes to hand. But current valuations and investor complacency leave little room for error if something goes wrong.

Performance periods unless otherwise stated generally refer to periods ended October 20, 2017

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