We have reached the half way point of 2017 and it feels like a good moment to reflect. Despite the concerns at the start of the year that geopolitical risk could dampen markets 2017 has, so far, offered investors strong returns across a variety of asset classes. A combination of good economic growth, low inflation and low market volatility have created a supportive environment for risk assets like equities and corporate bonds to perform. But can that growth continue?
In global equities for the first time since 2010, the performance of the rest of the world has been better than the performance of US equities.
In developed economies growth rates are now the strongest of any time since the financial crisis. GDP data is significantly above the pre-crisis high in the eurozone and dramatically so in the USA. Emerging countries are lagging, but almost all have joined in the upturn.
Given this pick-up in activity, the stage seems set for a burst of inflation. We do think we will see some inflation pressures soon, but so far inflation continues to look very subdued. This is despite low unemployment and very generous monetary policy, both of which tend to support higher inflation.
In our view, the current backdrop implies a market environment that favours risk assets, like equities, over government bonds. But the challenge is that risk asset markets have posted strong performance since the summer of 2016, so we think that the potential reward for investing is lower than before.
We think we are in a “fragile equilibrium”. The economic risks are two-sided. On the one hand, an obvious risk to market performance is a slowdown of growth, even if this seems unlikely at the moment. On the other hand, faster economic growth could also be problematic, because it could force the US Federal Reserve to raise interest rates more quickly than expected. That could destabilise markets.
Valuation risk is a concern
Yet more than anything, the key risk to the value of investments is valuation risk. This time last year many asset classes were extremely cheap. Today this is much less the case, asset prices are at more “normal” levels than in 2016, so if anything does go wrong there could be periods of volatility in the markets.
Risk asset overview
Both corporate bonds and equities are more expensive than they were a year ago because markets have been strong, but the economic environment remains supportive. What really matters is how the outlook will evolve compared with what the market expects. The challenge in corporate bonds is that prices already reflect the good news.
In equities, we have a preference for “rest of the developed world” equities over the US, in particular Europe and Japan. Emerging market equities are no longer as cheap as they were, but for now, and compared with the other opportunities available, we think EM equities continue to look attractive.
So far, this year, bond markets have delivered returns between 1 per cent and 5 per cent across a variety of asset classes. This is around a third of what they delivered in 2016 but returns are already close to our outlooks for the whole of 2017, so returns could yet exceed expectations.
Emerging market debt has delivered the highest returns so far, followed by high-yielding corporate bonds with ratings at BB and below.
The US Fed started raising interest rates, but cautiously, making sure markets didn’t overreact.
We expect US interest rates to continue to slowly rise, and as bond prices fall as interest rates rise, we expect to see a reduction in the price of government bonds and investment grade corporate bonds. This is one of the reasons why we prefer emerging market bonds to other parts of the fixed income universe. In EM local currency debt, interest rates are very high versus what is available in developed markets.
However, there are threats to bonds. Principally, if the Fed raises interest rates faster than expected because they are responding to significantly stronger inflation trends, there would be a fall in bond prices.
Global equity markets have been relatively strong so far, this year, delivering a better than expected performance despite significant geo-political concerns.
Major market events, including the unveiling of the new administrations agenda in the US, the rollout of Brexit, concerns around North Korea’s missile tests and the French elections all failed to derail the rally in equity markets.
Equities have raced ahead of our expectations for long-term returns since the beginning of this year and they are now a bit more expensive. Stock selection and regional mix will therefore we believe be even more important in the second half of this year. We aren’t expecting a significant downturn in equity markets, with the world economy seemingly on the mend and “reverse globalisation” failing to happen in the way that was previously feared. Yet we think equities have broadly reached “fair value”.
2017: sentiment and reality mismatch
For the second half of this year we may well see many investors who have been holding back on investing in more equities, particularly emerging market equities, step back in; this could drive the next rise in markets. This would prove an interesting contrast to those investors who tried to choose their entry and exit points for markets based on the predicted results of geopolitical events at the start of the year. Most have met with little success – proving that you should not try to time the market and a well-diversified portfolio is a far better option.
Joseph Little is chief global strategist at HSBC Global Asset Management