Our outlook for markets remains constructive as the trends we have seen unfold from the second half of 2016 through the first months of 2017 are likely to continue. What is different are the drivers of market performance. Last year and early this year, ‘risk on’ was underpinned by positive growth surprises and anticipation of pro-growth policies in Washington, but the tone has since shifted. The principal support today for equities is corporate earnings. Profits have rebounded in early 2017 in the US, but especially in Europe and even in parts of the emerging complex. Bond markets, meanwhile, remain on the defensive, largely because of expectations that the Federal Reserve will continue to normalise policy and because of a growing belief that the ECB will shift to a more neutral stance later this year.
Political uncertainty in the US recently made its mark on capital markets with a setback following concerns about potential obstruction of justice in the Trump administration. But it remains difficult to incorporate political uncertainty into everyday investment decision-making. Previous techniques, such as being long implied volatility, have not fared well over the past year. Rather, we believe robust portfolios comprised of differentiated strategies, including relative value, market directional as well as carry, are the best way to position against the unpredictable, including political disturbances.
Barring a major surprise, the probable outcome of the forthcoming UK general election is largely discounted into markets. Sterling has recovered on the basis that most investors believe that the Conservatives will have a historic electoral victory, building on their small majority in the House of Commons and giving Prime Minister May flexibility in negotiations with Europe. That said, we anticipate some negative surprises as the actual Brexit negotiations commence. The UK’s bargaining position, even if strengthened by a Conservative majority in the House of Commons, will be weak compared to the position of the EU as a whole and the interests of individual European countries.
In the US, we expect the Federal Reserve to continue its policy of rate normalisation with an additional rate hike in June and perhaps as many as two further hikes before year end. By the end of the year, the Federal Reserve is also likely to have made concrete steps towards normalising its balance sheet, including announcing how it intends to shrink its asset holdings.
The bigger surprise for capital markets is likely to come from the ECB. The ECB is currently pursuing not only extraordinarily accommodative monetary policies, but also has a bias to ease, which is likely to be changed fairly soon. The shift toward a more neutral public stance could come as soon as June, most probably no later than September, at which time markets will anticipate tapering and possibly the removal of negative deposit rates. Of those two central banks, we believe the ECB’s statements and actions are likely to be more impactful for markets than those of the Federal Reserve in the second half of 2017.