Markets continue to defy politics, this week shrugging off the ‘no’ vote to the Italian referendum and the resignation of Prime Minister Renzi. For now, the ‘reflation’ trade remains in force. While market resilience to political shocks is noteworthy, it can be largely explained by the durability of the world economy. Despite concerns this year about China’s imbalanced growth, the unknowns of ‘Brexit’ or doubts regarding America’s commitments to world trade and the international order in a Trump Presidency, global growth has remained remarkably stable, even showing signs of acceleration in recent months.
Purchasing manager indices point to a pick-up in global output. Meanwhile, steady increases in real household income in the US, much of northern Europe and Japan underpin demand. Downturns in Russia and Brazil appear to have bottomed, while rising metals prices suggest improved global industrial activity.
Resilient global growth has been sufficient to minimize market setbacks due to political uncertainty. Yet the reflation trade also reflects expectations for significant fiscal easing in the US, and to some extent in other advanced economies. The prospect of US tax cuts and spending increases against the backdrop of a nearly fully-employed economy has lifted US inflation expectations as well as the anticipated path of US short rates over the next twelve months, culminating in an 80 basis point jump in ten-year US Treasury yields since the US elections.
On most measures, for instance the ‘output gap’ or the difference between realised unemployment and the non-accelerating inflation measure of unemployment (NAIRU), the US economy cannot grow much faster in the short run without generating some additional inflation (Chart 1). Indeed, US wage inflation has already picked up (Chart 2), even if average hourly earnings dipped in the November employment report, probably owing to seasonal factors.
Markets are therefore largely correct in pushing up US (and global) bond yields, particularly if the Trump Administration primes the fiscal pump next year. And there is precedent. On two prior occasions (Reagan in 1981 and Bush in 2001) fiscal policy turned expansionary when Republicans wrested control of the policy agenda in Washington. Plausible scenarios (Table 1) suggest that over the next 1-2 years a combination of personal and corporate income tax cuts, plus increased military and infrastructure spending, could yield a US fiscal impulse of 0.9-1.8% of GDP.
Of course, as several Asset Allocation Committee members noted, legislation and implementation remain outstanding. Trump’s tax cuts and spending preferences may meet some resistance among fiscal conservatives in Congress, or could be scaled back by the need to adhere to ten-year budget guidelines. Moreover, infrastructure spending is likely to arrive with a longer lag, given that many potential projects are not ‘shovel-ready’.
Nevertheless, even after their recent sharp sell-off, US fixed income markets are not discounting unrealistic economic or policy scenarios. Ten-year implied US inflation rates (based on inflation-linked bonds) are presently about 2.0%, below long-term averages. The same is true for five-year maturities. While the market fully anticipates a quarter point rate hike from the Fed this month, at most two further hikes are discounted for 2017, hardly an aggressive view given a durable US economy operating near full employment.
Overall, therefore, the Committee believes conditions warrant continued overweight allocations to global equities, with corresponding underweight allocations to bond duration and investment grade credit fixed income. Within equities, cyclicals, financials and emerging equities are preferred to defensives, high-quality and low-volatility stocks. In fixed income, non-traditional sources of return offered by subordinated debt, non-agency mortgage-backed securities and insurance-linked bonds are preferred. Within alternatives, increased stock and sector dispersion ought to benefit long/short managers, with event-driven also likely to perform.
Finally, in terms of key risks for 2017, the Asset Allocation Committee cites rising US inflation (and a more aggressive Fed), China hard-landing and – yes - political risks (European elections, protectionism, geopolitical threats) as key sources of potential market setbacks in 2017.
The committee extends to our readers our best wishes for the holiday season and the New Year.