Following a year of synchronised global growth, strong equity markets and unusually subdued volatility, can investors hope for more of the same in 2018?
While our central expectation is for reasonably strong growth to continue in the new year – and this will probably be moderately supportive of equities – stretched valuations and a gradual turn in central bank policy are likely to present challenges to investors over the years ahead. Against this backdrop, Mercer outlines four themes we believe will be important for investors to consider when building portfolios in 2018.
From QE to QT
After almost a decade of monetary stimulus, the world’s major central banks are gradually starting to pull back, led by the US Federal Reserve. In response to low levels of unemployment and robust growth, the Fed recently announced a plan to normalise its balance sheet gradually over the coming years (referred to as quantitative tightening or QT). In November, the Bank of England implemented its first rate hike since 2007 and the European Central Bank has announced a reduction in the rate of asset purchases from January 2018.
We would, therefore, appear to be on the cusp of a shift in monetary policy – the end of an era in which central bank policy has been a significant tailwind for markets. The pace and scale of the shift from QE to QT will be critically important for markets in 2018 and beyond.
The open question is if and when policy might become an outright headwind for markets. A shift away from QE need not end badly, but there is no historical precedent for unwinding an easing program of this magnitude. Accordingly, we expect a more volatile market environment than the unusual degree of stability that prevailed during 2017.
In light of this shift, we believe investors should review the extent of interest rate duration inherent in fixed income exposures and consider floating-rate assets or strategies with limited structural duration, such as private debt, absolute return fixed income or asset-backed securities.
Equity markets will also be affected by the speed and scale of tightening, but the impact may differ substantially across stocks and sectors. Defensive sectors and high-yield stocks that have been treated by some investors as bond proxies could be particularly exposed to a rising yield environment.
Equity and bond markets have delivered exceptional returns in the post-crisis period, while also benefiting from a diversification effect due to their negative correlation.
The shift towards a tightening bias threatens both of these trends. Investors should be prepared for an environment of lower returns from equities and bonds, plus the possibility that the diversification effect could disappear, with equity and bond returns becoming positively correlated, as has been the case for long stretches in history.
This is an important consideration for investors making use of leverage (for example, in risk parity strategies) and suggests that portfolios dominated by passive equity and bond exposure offer an unattractive prospective risk/reward profile.
Preparing for late-cycle dynamics
The later stages of a credit cycle typically present a challenging environment, offering lower returns and greater risks than the early- or mid-cycle periods. Although we expect the current economic strength (evident across much of the global economy) to continue this year, we believe investors should start considering the ways they might prepare portfolios for the risks and opportunities the late stage of this credit cycle might present.
As cyclical conditions evolve across the global economy, we believe the following issues warrant discussion:
Investors should be wary of reaching for yield, especially in credit markets offering historically low levels of compensation for default risk. In particular, we view investment-grade credit and high yield as unattractive, with current yields and spread levels offering relatively little upside. Similarly, investors should ensure that they are able to receive sufficient compensation for illiquidity and complexity when accessing less liquid markets.
Reduced levels of liquidity may increase the magnitude of any sell-off in markets, as illustrated by the flash crash in 2014 and the market falls of early 2016.
In addition, an increasing volume of assets is now managed in a way that could increase gap risk in markets. In particular, risk parity, volatility control and trend-following strategies, along with exchange-traded funds that provide short volatility exposure, could all amplify a market sell-off. Periods of market stress reinforce the importance of stress-testing and appropriate position-sizing, but they may also create opportunities for investors willing and able to behave in a contrarian manner.
Conversely, if central banks are able to reduce monetary stimulus without upsetting markets, emerging markets (both equity and debt) are likely to benefit from a combination of early-cycle dynamics, relatively cheap currencies and strong global growth. Under our central scenario, we expect emerging-market equities to outperform developed-market equities, perhaps for some time.
Since the early 1980s, there has been widespread convergence, across large parts of the developed world, towards neoliberal policies broadly centred on free trade, free markets and reduced state intervention (deregulation). In recent years, we have witnessed a backlash against the mainstream (‘establishment’) politicians and parties that have upheld this consensus, resulting in the rise of populism across large parts of the Western world.
This fragmentation of the liberal free market consensus creates an environment in which political uncertainty is heightened, with a higher probability of significant shifts in policy. We believe investors should stress test portfolios against large equity, bond and currency movements. Investors who might struggle to tolerate large market movements may wish to consider ways to manage their downside risk exposure, including outright de-risking, defensive tilts or explicit hedges.
A fragmenting political consensus, fueled by a rise in populist resentment of elites, might also become more openly hostile towards corporate profits and monopoly power. Over time, this could lead to a reversal in the multi-decade trend favouring capital over labor (as a percentage of GDP), leading to downward pressure on profit margins.
Similarly, more empowered regulators might seek to take action on aggressive taxation policies and the dominance of large tech firms. Such actions need not be unambiguously bad for equity or credit investors – it is quite possible that intelligent regulatory interventions might help reduce the risk of more extreme political outcomes – but they clearly do create tail risks for certain stocks and sectors of the market.
Stewardship in the 21st century
In recent years, we have seen an increasing recognition of the importance of institutional investors’ role as stewards of capital, along with a wider discussion around the role of finance in promoting the social good.
In particular, there has been a clear trend in the treatment of fiduciary duty towards recognising the importance of ESG issues. We see this as positive, having explicitly stated for many years our belief that an engaged and sustainable investment approach, especially one that recognises the importance of ESG issues, is likely to help create and preserve long-term investment capital.
For long-term asset owners, the critical components of a sustainable investment approach can be considered at three levels:
Asset owners should have a clear set of beliefs on: the impact of ESG factors on risk/return outcomes; the importance of stewardship and engagement activity; and any investor-specific factors that might affect their approach. Investors should also determine which collaborative industry initiatives can help them address related issues in a resource-effective manner.
At the strategy level, asset owners should ensure that their strategic asset allocation is consistent with their beliefs and policy. Beyond this basic requirement for consistency, investors should also be clear on the extent to which systemic risks (in particular, climate change) can be expected to affect the risk/return characteristics of their portfolio.
At the portfolio level, asset owners should ensure that their underlying managers integrate appropriate consideration of ESG issues into their investment processes and take their stewardship responsibilities seriously. This applies equally to active and passive managers.
Moving beyond sustainability and ESG considerations, there is a wider debate taking place concerning what has been described as a “crisis of capitalism”.
As touched on under our fragmentation theme, this discussion typically revolves around issues of rising inequality, the rent extraction of elites, corporate and investor short-termism, and insufficient consideration of social and environmental externalities.
While it is far from clear where this debate will lead, what does seem clear is that politicians and policymakers (reacting to a loss of public trust in finance and capitalism) will seek to find ways to align corporate behaviour more closely with social wellbeing. This will apply as much to the investment industry as to any other part of the economy and will require all parts of the investment chain to demonstrate their value to society in order to maintain a social licence to operate.
The ideas outlined above represent our observations on the challenges, opportunities and drivers of change present in the current investment environment. We provide these ideas with the aim of provoking debate and discussion around the appropriate response to a changing and changeable market landscape. We look forward to continuing this discussion over the course of 2018.
Phil Edwards is global director of strategic research at Mercer.