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Policy uncertainty and increasing populism poses risks across global markets, but not necessarily a threat to global growth, says Neill Nuttall.
It’s tautological to describe trade as a global issue. But it is worth emphasizing, as we think that investors face a particularly global set of risks this year. Policies around trade, protectionism and immigration are just a few of the uncertainties arising from the new US administration's transition to power. Indeed, we think that transition in the US is emblematic of the global trend of rising populism (see 2017 Outlook “Trump’s First 100 Days”).
As we review the key risks for 2017 and in particular the first half of the year, we are focused on policy uncertainty in the US, notably in the areas of fiscal policy, deregulation and trade; the electoral cycle in Europe where populism makes the outcome more uncertain than usual; a hard landing in China, which we address later; and a potential inflation scare that may lead to a disruptive increase in rates.
Economic and market volatility have stayed low for years, and we expect steady but broader global growth this year, which typically would not be an environment for increasing volatility. However, the volatility of volatility itself has settled at a higher level than earlier in the cycle. We consider this uptick an alert to remind investors that an environment of rising rates— which has prevailed for the last six months or so—may end with a sudden market dislocation.
We do see a risk of intermarket volatility, where a rapid repricing in one market causes asset prices to fall in others. We are focused on the potential for a spike in rates, especially as markets reassess inflation, which would be likely to affect equities and credit. You need a very diversified portfolio to mitigate that left-tail scenario.
The new administration in the US is clearly the focus of this populist trend. Aligning portfolios to a more literal translation of Donald J. Trump from candidate to president requires us to be nimble and opportunistic. The administration is shifting the emphasis of policy in three directions: deregulation, fiscal easing and trade. So far we think markets may have over-priced the potential positive implications of the first two on relatively little information. For example, from election day until the end of the year, US oil and gas and banking sectors outperformed the S&P500 by 19% and 15%, respectively.
Markets are now at risk of being disappointed by the scale, or at least speed, of reform. We also think markets may not have priced enough downside from the effects of trade renegotiation and a more introverted US. Importantly, we don’t see the new administration’s three axes having much impact on growth this year, except at the margin through the confidence channel. We see other risks to actual output stemming from the potential for a much faster-than-expected pace of Fed hikes and commensurately stronger dollar, which could over-tighten financial conditions.
Source: GSAM Global Portfolio Solutions (GPS). As of January 2017. *Note that this does not account for liability-driven investment.
We think populist trends could also drive volatility in Europe. We expect the UK will take the brunt of the machinations of leaving the European Union, in terms of impact on output and market reaction from headlines, as we’ve already seen from the ricocheting pound. In the Eurozone, the heavy electoral calendar presents a tail risk. In our experience markets tend to focus late on elections, causing volatility to crescendo immediately prior to the vote and dissipate quickly after. Absent a very market-negative outcome, that behavior can be beneficial from an investment perspective as it creates tactical opportunities. In aggregate, we do not expect major upheaval in 2017 in Europe and we think that growth will continue on its accelerating trend.
We do not expect global growth to be much higher this year, but we see positive contributions from more countries. We are focusing particularly on emerging markets among this broadening base, notwithstanding trade dynamics, which will have individual winners and losers. We think a potential rewidening of growth rates between emerging- and developed markets, plus depressed sentiment and valuations and improved external balances, are supportive for our current overweight to emerging market equities. The main counterbalancing risk is China, where very high and rising debt levels increase the chances of a policy error or hard landing that could have a material impact on global growth. However our analysis suggests the real estate market is in reasonable health and, even allowing for the growth in shadow financing, non-performing loans are unlikely to reach a scale to threaten the broader Chinese economy.
Both rates and equity valuations are widely considered to be high, which can increase investor nervousness and exacerbate bouts of volatility. However, we think equity and credit markets are fairly valued given prevailing macroeconomic conditions and the level of interest rates. Indeed, in emerging markets, as I said, valuations are part of the reason to be overweight. We think that where markets are mis-valued relative to economic fundamentals is in rates, as we have argued before (see 2017 Outlook, “The Long Cycle Continues”). We are comfortable in our overweight to equities, especially relative to bonds.
