At the very heart of the challenge for investors in 2017 lies the push and pull relationship between central bank policy and the fiscal landscape. For most of 2016, market participants have not regarded low interest rates, anemic demand growth or low inflation as likely to change any time soon. But with his campaign commitment to use government spending and lower tax rates to spur demand growth, Donald Trump’s US election victory appears to have altered the monetary and fiscal policy balance and the wider ’lower for longer’ narrative in an instant.
Even prior to recent political developments, the structural imbalances and unintended consequences caused by low policy rates and quantitative easing were starting to be seen as outweighing the benefits.
In September, the Bank of Japan announced its intention to target a specific yield on secondary government debt rather than specifying the quantity of bonds it intended to buy – as it had done previously. This suggests that policy authorities are finally beginning to think differently as to how best to stimulate growth and inflation more effectively and more sustainably. The potential for meaningful change in the inflation and interest rate narrative has not been lost on investors. As 2016 draws to a close, we are witnessing a marked upward shift in bond yields.
We see increased government spending – traditional fiscal stimulus – as the next step in a number of countries including Japan, the US and the UK, dependent on budgetary constraints. Whether this extends towards a new framework of central bank-financed government spending (so-called helicopter money) remains a key question. But any progress towards such initiatives is likely to be gradual given the political obstacles that need to be overcome.
Indeed, while 2016 has hardly been short of headline-grabbing political events, politics still has the potential to impact investor confidence again in 2017. Dissatisfaction with establishment politics has been evident in the UK’s decision to leave the EU and the victory of Donald Trump in the US presidential election. There is a busy calendar of potential flashpoints in the months ahead including elections in both France and Germany. In short, geopolitical risks remain high.
Of course, while investors face many common challenges, we are well aware that their context and impact is client specific. There is no ’one size fits all’ to the issues that dominate markets.
The responses highlight that the move towards increased fiscal spending and the potential for higher US inflation may benefit cyclical sectors within developed global equity markets and banks in particular. This backdrop is also likely to offer continued support to risk assets more broadly as real interest rates remain extraordinarily low relative to historic standards.
And despite the headwind of a strong US Dollar (USD), we believe that emerging market equities will remain supported by attractive valuations and powerful demographic trends. Meanwhile, an active approach and the ability to exploit tactical opportunities may be key to returns in bond markets in 2017.
While our investors highlight a number of challenges in the months ahead, there is a recurring theme throughout: dislocation in markets and changing price relationships relative to historical norms continue to present compelling opportunities across global asset classes for the right strategies and skilled investment professionals to deliver the outcomes that clients expect.
Dawn Fitzpatrick is head of Investments at UBS
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