19 February 2018
Chief economist and head of GAM Investment Solutions, Larry Hatheway, discusses the changing macroeconomic environment, including whether we are reaching the end of the equity bull market, his expectations for inflation and monetary policy and the implications for portfolio construction.
We believe it is too early to call the end of the bull market. We are still in an environment of strong global growth and rising earnings, particularly in Europe, the emerging economies and in Japan, which should support further equity gains. However, we are entering a new phase that will be characterised by more volatility and further corrections. That is driven by growing uncertainty in the macro environment. Inflation is beginning to show the first signs of acceleration in the US, which we are also likely to see in Europe. This calls into question the predictability of monetary policy which has supported equity markets. The dynamics will change going forward, even if equity markets still advance this year.
With regards to inflation, the latest figures from the US show both a surprising jump in both headline and core rates. We have also seen some evidence in the US that wage inflation is picking up and we saw higher than expected wage settlements in Germany, another sign that labour markets are tightening and bargaining power is reverting to labour.
There are some positive side effects of rising wage inflation, including easing debt burdens, more even distribution of income and we are likely to see fewer people disaffected by the nature of the recovery. However, it poses challenges for corporations in terms of profitability and for central bankers in terms of how fast they should adjust monetary policy.
We are entering a new era, which we prefer to call the post new normal. The new normal was characterised by low growth, low inflation and supportive monetary policies. In the US, we began that exit several years ago as the Fed began the process of normalisation. The ECB is also preparing to wind down its asset purchase programme and by next year is likely to raise rates. The Bank of England and the Bank of Canada, amongst others, have also begun to raise interest rates.
We are in a maturing cycle in parts of the developed economy. Growth in revenues is likely to remain strong for the corporate sector but growth in the bottom line less so, above all in the US where there is little scope to expand profit margins. For investors, the kind of predictability that we have seen from central banks is replaced now by a need for central banks to make sure that they do not overstay their welcome. That changes the overall tenor of how investors should operate in these markets.
All of the above has strong implications for portfolio construction. In the quintessential portfolio, a blend of stocks and bonds aims to provide return and diversification. The current environment is far less favourable to bond markets, specifically long term government bonds. Furthermore, the corporate risk credit spreads and yields are low relative to what we would expect. Accordingly, portfolio construction must become more attuned to fixed income risk.
Equally, among equities allocations must be more selective. We prefer shares that have the ability to beat earnings expectations, which increasingly include companies in Europe, emerging markets and in Japan.
We will inevitably hold fewer bonds going forward than would be normally seen in balanced portfolios. This opens up opportunities for non-directional strategies and liquid alternatives, including alternative risk premia or target return, strategies that are designed to generate uncorrelated returns. It is time for those strategies to step up and provide the kind of portfolio stability that traditionally bonds would but are no longer able to do.
Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Allocations and holdings are subject to change.