Normalisation is coming: keep calm and carry on
2017 was a strong year in terms of multi asset returns. The stars were aligned to create a supportive market environment, with economies delivering above potential growth, inflation pressures remaining subdued and major central banks (largely) maintaining accommodative monetary support. This combination of outcomes resulted in a ‘Goldilocks’ economic scenario, where the economy is neither too hot (generating inflation), nor too cold (creating a recession). Multi asset portfolios benefitted from this environment with both growth and hedging assets delivering positive returns.
2017 did see a change in stance by several central banks and, in our view, 2018 will see the continued reduction in asset purchases and an increase in interest rate rises. Moreover, we expect the impact of unplugging this monetary drip, even if handled with care, is likely to affect assets in many ways. Even so, we believe there are ways investors can prepare for change in the macroeconomic and monetary backdrop and even benefit from it.
2017: The central bank transition
Over the course of the year, central banks started adopting a different stance in terms of forward guidance and quantitative easing programmes. Their meetings have been highly scrutinised by markets, with any unexpected changes triggering sudden volatility episodes. The Federal Reserve (Fed) learnt the hard way in 2013 with its Taper Tantrum communication error and has since mastered the art of preparing markets with subtle communication tricks.
As a result, the Fed has been able to deliver on each of its promises since late 2016 with no major disruption: interest rates have been raised in line with the dot plot and the balance sheet runoff has started. This has occurred in spite of what the Fed calls the “Inflation Mystery”, with Fed speakers favouring normalisation in light of the temporary forces that were preventing prices from moving higher.
The European Central Bank (ECB) also widely signposted its intention to reduce asset purchases by half in 2018. ECB expectations were again managed with great care in the early part of the year, with the aim of lowering market stress and avoiding another taper tantrum “mistake”.
The euro reaped the benefits from this change in stance to surge 14% against the US dollar for the year, its first positive annual return in four years. Conversely, European sovereign yields failed to rise substantially as price pressures kept undershooting the ECB’s 2% target.
Other central banks acted without preparing markets as well. For example, the Bank of Canada (BoC) surprised with two consecutive hikes, in a move to fight off a growing housing bubble, which drove local bond yields off track to significantly underperforming their global counterparts.
Chart 1 illustrates how monetary policy changes can negatively impact the relative value of assets, showing the evolution of Canadian 10y bond yields against peers over the course of 2017. The surprisingly hawkish stance adopted by the BoC sent the average spread up almost 100 basis points (bps).
Chart 1: Surprise change in Canadian monetary policy harmed local bond markets
Chart 2: Interest rate decisions from major central banks – the tide started turning in 2017
As shown in chart 2, 2017 witnessed a change in stance from central banks and a “lift-off” in interest rates decisions – this is the first time since 2010/2011 and could well mark a turning point for the years to come. Nevertheless, it did not hinder growth and hedging assets, as discussed earlier. Companies were increasingly profitable, unemployment fell, consumption rose and market stress was particularly muted.
The biggest surprise of the year came from developed market sovereign bonds, where average yields ended the year at a similar level to where they started. Despite three rate rises, US 10y treasury yields ended the year at 2.40%, which is a small change from where they ended 2016 at 2.44%. These hikes affected short-term rates, which in turn changed the slope of the curve: the 10y-2y spread dropped more than 70bps to approximately 50bps. We have not witnessed yields at this level in 10 years – reviving fears of an inverted yield curve and a possible recession.
Is the last rampart against more normalisation about to fall?
In our view, disruption in 2018 will come from inflation, forcing central banks to accelerate normalisation. It is important to distinguish between normalisation and tightening – the former is necessary to avoid falling “behind the curve” and bearing the risk of unintended financial excesses, the latter should only be used in the event of the global economy overheating, which is not yet the case. In many countries, central banks have acknowledged the robustness of their current economic conditions, but have also voiced concerns over missing inflation targets. We believe ignoring inflation would be a mistake as it could lock-in low interest rates for longer.
Charts 3 and 4 compare the current level of interest rates and their theoretical fair value, proxied with the Taylor rule (based on growth and inflation premia and how they appear to be overly loose). We believe that it is now time to close this gap, and set rates closer to their “normal”, fundamental levels.
Chart 3: Central banks ought to bring back interest rates to their “normal” fundamental level
Chart 4: The ratio of decision rate to Taylor rule does not leave room for interpretation -monetary stance is excessively accommodative
While inflation has been keeping central banks from engaging in an aggressive removal of asset purchasing programmes and rapid rate increases, we believe this situation may change in the coming months.
Reflation has been a key focus for our asset allocation since July 2016, as we believed economic forces were moving in that direction even before Donald Trump’s election. On chart 5, our inflation nowcaster demonstrates the end of the 2014-2015 deflation periods. While wages and production costs have been on the rise across developed economies over the last couple of years, inflation figures have failed to hit levels that would cause concern across markets.
According to the IMF’s latest World Economic Outlook, developed economies’ prices grew 1.5% in 2017, moving from 0.52% in 2015 and 1.48% in 2016. While we believe deflation is behind us, inflation struggled to rise in 2017. As displayed on Chart 5, our world inflation indicator has failed to reach levels as high as those observed between 2004 and 2007.
Chart 5: World inflation nowcasters
In our view, low goods inflation has been the main driver of the disappointing inflation figures in recent years. On average, goods account for roughly 20-30% of consumer price index (CPI) baskets. Over the past 15 years, goods inflation has grown by 1.5 to 2% per year on average; however since 2013 the growth rate has collapsed to nearly 0%.
The US is a perfect illustration of this trend (chart 6), as the growth of its goods inflation has been lower than usual. The decline in commodity prices observed since 2014 and its pervasive effects has been one of the key drivers to this slowdown: as input prices dropped, producers had nothing to relay to the end consumer, partly explaining what is missing in terms of overall inflation.
Chart 6: Goods inflation vs. Producer Price Index in the US
As commodity markets started to recover, we believe producer price indices have started rising again. Historically, this rise has a lag of 18 months in conjunction with goods inflation; we therefore expect to see an increase in goods inflation in 2018, with growth rates gently rising towards their historical average of 1.5%. In our view, this should not result in a sharp inflation rebound to levels markedly above central banks’ targets; however a rise in consumer price inflation should trigger an era of normal inflation, where normalised monetary policy will naturally arise.
The normalisation of inflation will not only be sustained through the return of higher goods inflation; we believe that strong growth across developed economies will also play an important role. Our growth nowcaster for developed economies has been consistently depicting above potential growth for the past 14 months and is accelerating further at this moment in time.
Consumption has been the main driver behind this cycle since 2009, but investment is also starting to come through, in both its residential and non-residential components. In our view, these elements should be supported by today’s synchronised growth picture, although it may take some time to see a relay from economic activity to price level.
Finally, we believe one of the greatest lessons from 2017 is the understanding that even though inflation pressures are building, it may not necessary lead to a surge in the pricing of inflation in markets. As illustrated in chart 7, when the Fed prepared its first hike in March 2017, inflation expectations and real assets globally gave way; yet, the Fed was perceived to be ahead of the curve and tamed inflation expectations. These two hikes have been followed by a converse move, and the 10-year inflation breakeven in the US moved from 1.7% to 2% between June and December. We believe that the change in the Fed’s stance from being ahead of the curve to moving behind, is a game changer and could open the door to a rally in real assets in 2018, as inflation expectations rise.
In summary, we think inflation-related assets could deliver strong performance this year for the following reasons:
- The likelihood of increased inflation now exceeds the possibility of deflation returning.
- The normalisation of goods inflation should lead to stronger core and headline inflation across many countries (with varying intensity).
- The Fed and other main central banks are not aggressive enough given the macroeconomic backdrop, allowing inflation related assets to extend their positive trend.
Chart 7: Performance of our macro baskets’ in 2017
Reading note: To monitor the macro-factors, we construct baskets of risk premia linked to risky assets whose trends are closely related to that of the corresponding factors. “Proxy” risk factors are constructed as follows: Growth: risk-weighted equities (MSCI World) and credit spreads (CDX NA HY) / Inflation: basket of commodities and inflation swaps (33% Bloomberg Energy, 33% Bloomberg Industrial Metals, 33% Global Inflation Breakeven).
What will happen to markets when inflation returns to normal?
In our view, the current economic environment is negative for bonds, while being positive for equities and real assets. We believe bond markets have two enemies: one is the return to normal inflation as an inflation premium is embedded in government bond rates; the other is the growth premium – real rates – that reached new lows in 2017 as shown in chart 8.
Chart 8: Real rates remain negative, limiting investors’ income returns and helping equities look attractive
We anticipate seeing a correction at the short end of the curve as expectations of normalised monetary policy start to emerge. Additionally, we think a structural adjustment at the long end of the curve is also necessary. Chart 9 illustrates the market expectations of the Fed’s “terminal rate”: the ultimate target for its decision rate, as measured by the first 3-month forward rate in 10 years. Three periods are clearly depicted: before 2008 – a period when the expected terminal rate was in the region of 6%; post 2011 – when expectations for the terminal rate fell to 4% and since 2015 when it further dropped between 2% and 3%.
Using the Taylor rule, which is based on longer run inflation and output gap, this move is far from being an oddity. Yet, current normalised inflation implies the terminal rate is probably 1% above the current value and therefore leaves the door open to higher 10-year rates.
Chart 9: Terminal Fed rates implied by the US yield curve
So how will equities perform in an environment of higher inflation and rising interest rates? Historically, this has been positive for equity performance. Chart 10 shows average monthly returns during rate hikes versus average monthly returns over the full period, since December 1997.
In our view, the chart highlights that equities post higher returns when monetary policy becomes less accommodative. We believe this comes from the fact that central banks hike rates during “good times”, when the macroeconomic backdrop is favourable, to avoid an overheat. Stock markets also outperform during these favourable periods.
We have now reached a time of a tighter monetary policy across developed economies, with monetary policy becoming less and less accommodative in 2018. Under these circumstances, we expect most equity indices to respond positively to increases in decision rates.
Chart 10: Equity indices performance in tightening periods vs. trend average returns
Keep on navigating and brace for larger waves
It could be easy to forecast a completely different story for 2018 to 2017 given current levels of certain assets, such as equities, bonds and commodity prices. Exuberance has been going on for so long that it leaves investors with a crucial choice to make: stay invested or take profits. Be greedy or regret.
From a macroeconomic standpoint, there has not been such strong and synchronised growth momentum since before the great financial crisis and we believe this framework will continue to be highly profitable for risky assets. The steady repricing of inflation should steer central banks away from extraordinary measures, without having to actually tighten monetary conditions – a necessary step when the economy overheats. The pace of this normalisation will be key, and even though there will be surprises along the road, we expect action will be well signposted so that macro and financial stability is not put at risk. As stated previously, we expect inflation to return and, in our view, the pricing of this seems currently too low. We believe this could create disruption across bond markets, which could suffer net losses.
The good news is that we believe there are ways to protect against this less accommodative backdrop, while maintaining exposure to risky assets. Our approach favours staying fully invested, but changing the mix of growth and hedging assets. We are also tactically reducing duration in favour of inflation -linked assets, that should be less sensitive to interest rate rises and have the potential to capture the repricing of inflation expectations. In our view, the regions most at risk from a rapid surge in sovereign yields are Europe, the Nordic countries and Japan, where the current level of accommodation is no longer justified.
Currencies could also be impacted. We expect monetary convergence to lift those currencies where the gap between macroeconomic strength and central bank accommodation is the largest. In this respect, the Japanese yen appears very appealing: as well as its defensive characteristics, economic growth in Japan has been accelerating, inflation has been showing signs of modest revival, yet the Bank of Japan policy is currently among the most accommodative of the G10 countries. On the other hand, the US dollar has been soaring on the back of positive developments on the fiscal front and the implication this could have on inflation in the US. A rate hike in March from the Fed is already 80% priced in the market, as well as another hike later in the year. As we do not expect the Fed to fall behind the curve and become any more aggressive, we are in favour of the US dollar right now.
As stated earlier, we believe the need to adapt diversified portfolios to these more challenging market conditions will become dominant in 2018. We do not expect risk assets to achieve comparable returns this year to those of 2017 and we believe the opportunity set will be largely driven by relative value exposures over pure beta plays, especially in foreign exchange and sovereign fixed income assets. We will continue to maintain exposure to growth assets, with a preference for equities (as long as the economic environment remains sound), alongside a layer of hedges in order to achieve an asymmetric return profile, while prudently participating in any risk-on rallies.
Sources: Bloomberg, IMF, Unigestion calculations, as at December 2017.
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Document issued on: 25.01.2018