Date
12 December 2017
The Goldilocks scenario of low inflation and robust growth is now widely accepted among investors. Despite equity indices scaling one high after another, Philipp Baertschi believes equities offer the greatest potential. Photo: Reuters
The Goldilocks scenario of low inflation and robust growth is now widely accepted among investors. Despite equity indices scaling one high after another, Philipp Baertschi believes equities offer the greatest potential. Photo: Reuters

Goldilocks forever?

The Goldilocks scenario of low inflation and robust growth is now widely accepted among investors. Central banks appear to have achieved their goals and can start to raise interest rates gradually. Under these circumstances, it is hardly surprising that implied stock market volatility has reached new lows. With equity prices shrugging off geopolitical crises in the Middle East, many investors cannot imagine a trigger capable of upsetting financial markets.

Global synchronous upswing

At the start of the fourth quarter, the latest economic data delivered yet another positive surprise. For the first time since 2010, manufacturing industries in the United States, Europe and China are all expanding. Improvement seems likely, and indicators could remain positive, signaling above-trend growth.

The US Federal Reserve plans to raise interest rates before the end of the year, not least due to robust growth. The next governor, Jerome Powell, is likely to continue the gradual normalization of interest rates. We do not expect the European Central Bank to start raising rates until 2019. There is nothing to suggest that central banks will dampen the current recovery precipitously.

Inflation facing a trend reversal?

Given limited threats to the Goldilocks scenario, inflation is more likely to deliver surprises. Inflation rates have not increased in recent quarters, despite the robust growth. In the first half of the year, this could be explained by the falling price of oil, but this is no longer the case.

At least in the US, rising core inflation would be normal due to increasing capacity utilization and the falling unemployment rate. Core inflation data tends to follow the ISM Manufacturing Index with a two-year time lag, so inflation may increase over the next few months.

Yet, surprisingly, inflation expectations have not moved. Even the sharp increase in oil prices barely made an impression, though rising oil prices strongly correlate with higher inflation.

For investors, it raises the question of whether bond prices would drop sharply if it became evident that central banks had underestimated inflation pressure. More specifically, a sharp rise in long-term rates would lead to higher financial market volatility, potentially jeopardizing the Goldilocks scenario.

Are bonds immune to inflation?

We believe that the short end of the yield curve would be hit hardest by a temporary rise in inflation, with the market pricing in more rate hikes than expected. The long end of the curve should remain relatively stable, provided the market does not reassess the terminal federal funds rate, which is seen at about 2.5 percent.

If the Fed increased interest rates too quickly, long-term interest rates might even fall. Hence, long-term US bonds offer good protection against the risk of excessive monetary policy tightening. Conversely, for investors who are concerned that the Fed might move too slowly, inflation-protected bonds represent a good hedge.

Gradual reduction in credit exposure

Positive market sentiment has seen corporate bond spreads narrow even further. This spread tightening was not accompanied improved fundamentals, but driven by rising risk appetite and the search for yield. The corporate debt situation, particularly in the US, has actually deteriorated. We, therefore, take a very selective approach to new credit risks and have reduced the allocation to corporate bonds in our fixed income investment and multi-asset investment strategies.

Emerging markets (EM) bonds still offer a higher spread than developed markets (DM) bonds. In addition, the fundamentals of many EMs continue to improve. We, therefore, favor EM investment-grade and high-yield bonds.

These markets offer another advantage: they issue more new bonds. We also see a good tactical opportunity in EM bonds in local currencies. A number of these currencies have suffered in recent weeks due to the rebound in the US. Based on our positive outlook for the global economy, we expect an above-average performance for these bonds.

Investment strategy: Equities favored

Despite equity indices scaling one high after another, we still believe equities offer the greatest potential. We remain overweight equities, and favor cyclical markets and sectors. In EM, we have an overweight position in both equities and bonds.

We have reduced the allocation to high-yield bonds and favor convertible bonds, which offer much more potential when stock prices rise. In currencies, we have reduced the active risks and taken currency profits in Swiss franc portfolios.

– Contact us at [email protected]

BN/CG

Chief Investment Officer, Bank J. Safra Sarasin

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