Towards a possible end of the low-growth, low-inflation environment

We expect 2017 to progress towards the end of the low-growth, low-inflation environment which has prevailed since the Great Recession and we are anticipating an increase in market volatility. We acknowledge that the range of possible outcomes is unusually high, including both upside and downside risks to our core scenario. Given our confidence in the sustainability of positive global growth and rising inflationary pressures throughout next year, Candriam is overweight equities vs bonds.

Regime change in the US

The election of Donald Trump as 45^th President of the US and the Republican clean sweep represents a change of regime in the US. It should be noted that the political alignment between the President and Congress is the exception rather than the rule, as there have been only 18 clean-sweep years over the past half century.

Since 1965, the US budget deficit has widened by almost 0.5 of GDP point annually on average when legislative and executive powers were aligned, vs an average fiscal tightening of nearly 0.2 of GDP point when they were split.

As a result of the US elections, the prospect of increased fiscal easing has risen considerably, given Donald Trump’s programme. Even though the specifics and the size of the stimulus package still have to be nailed down, a dose of US reflation is allaying end-cycle anxieties among market professionals. Ultimately, Candriam expects stronger US growth over the coming months. We expect equities to outperform due to rising corporate profits, improved confidence readings and stable equity multiples and we are buyers of US equities. We are adding to Japanese equities, which benefit from improved US outlook and represent a hedge if the US dollar appreciates more than expected.

Simultaneously, this regime shift will likely result in higher inflation as well, as the US economy is already operating close to full employment, leading to rising wages. Furthermore, as commodity markets have bottomed in 2016, global deflationary pressures are also receding. We expect bond yields to rise in 2017 based on fiscal easing and rising wages in the US, receding Chinese deflation and potential protectionist measures and we are therefore reducing duration, buying linkers and buying value equities.

We identify five challenges for asset management in 2017

Rising interest rates and bond yields. We have gained conviction that bond yields troughed post-Brexit. Fundamentally speaking, sovereign bond yields have become over-valued after 35 years of bull markets. According to research from the Federal Reserve Bank of New York, the term premium of 10y US Treasury yields reached an unprecedented low point last summer (-75bp on 8 July 2016). If this diagnosis proves accurate, risk has switched from equities to bonds in the form of duration risk. Higher global bond yields would signal reflation, which should not represent an obstacle for stock markets.

Policy error risk. Over the medium term, the wide range of possible outcomes of the forthcoming Trump presidency includes policy error risk. An aggressive policy mix could lead to a misallocation of resources or an interest-rate shock which would significantly tighten financial conditions. If bond yields rise too fast and too far, there is a risk of a sharp tightening in monetary and financial conditions, which would be detrimental to stock market performance. Further, the introduction of protectionist measures could swing the pendulum from a “reflationary” environment towards “stagflation”. An interest rate shock due to higher inflation outlook, not supported by rising growth expectations, would signal stagflation.

Central bank decoupling. The expected policy gap between the US and the rest of the world implies re-alignments in currency markets. We expect the Federal Reserve to continue, or even accelerate, its tightening, while the ECB, BoE and the BoJ will do their utmost to prevent any adverse spill-over of rising bond yields. The US Fed tightening cycle is at odds with accommodative policy in the Eurozone, the UK and Japan. At the end of the day, this should lead to a stronger USD and a weaker JPY and boost exporters outside the US.

Greater risks are being priced into emerging markets. The improvement in both domestic and global economic conditions and the stabilisation in commodity prices certainly provide support for emerging markets. However, we cannot ignore the fact that the economic outlook is at risk after Donald Trump’s victory, and not only as a result of potential protectionist measures. Higher US rates imply downward pressure on currencies, which might result in capital outflows. The valuation yardstick, however, indicates an attractive levels.

Political uncertainties in Europe. Economic policy uncertainty did not disappear on US Election day. The results of this year’s polls have increased investor anxiety over politics in Europe. In particular, investors fear that the referendum in Italy, upcoming general elections in the Netherlands and presidential and general elections in France and Germany might put the integrity of the Eurozone at risk. The start of the Brexit negotiations will add further uncertainties to the region and the conditions of the Brexit and its impact on the economy are nowhere near resolved. We note that investor positioning has been rather cautious ahead of the votes in 2016 as cash ratios in portfolios have been historically high and money has been put back to work in the aftermath of the ballots. In addition, central banks are now used to following the financial crisis template and are ready to provide ample liquidity to markets, which has reassured market professionals.

Conclusion

Even though the range of possible outcomes of a Trump Administration is unusually high, Candriam expects the regime change in the US to reverberate on global financial markets. The most likely outcome is that we will see higher inflation and stronger growth in the coming months. In the longer term, higher bond yields, rising deficits and political uncertainty could lead to market vulnerability. In terms of asset allocation, risk appears to have switched from equities to bonds as the prospect of a US recession in 2017 has diminished. As a result, we are reducing duration, buying linkers and are positive on value equities. We expect stronger US growth over the coming months, led by reflationary measures through fiscal stimulus, tax cuts and regulatory easing in an already robust labour market context. We are therefore overweight on equities, in particular in the US and Japan.