Are we headed for more normal economic conditions? Part 1
Despite near-term risks, AMP Capital continues to expect 2017 to be a year of “reflation contagion”. This is good news for investors.
This is the first in a two-part article series that explores AMP Capital’s views about current events in the global economy that self-managed super fund (SMSF) investors may wish to keep in mind when considering how they manage their own fund.
These views impact investment decisions for the Dynamic Markets Fund, which uses risk mitigation tools such as options and other hedging instruments to protect investment funds from adverse market movements.
Here, we look at factors driving global growth. The second part of the article explores how our views on these variables are expressed through the portfolio’s asset allocation.
Setting the scene
In a reflationary environment, governments tend to roll out policies to expand economic growth and prevent deflation, which happens when asset values decline.
Policies to drive reflation can include tax cuts, lower interest rates and accommodative monetary supply.
Governments tend to pursue strategies to drive reflation when economic growth is expected to pick up and in an environment of benign monetary policy.
This leads to higher inflation expectations and higher bond yields, which in turn is expected to reduce the strong demand for yield seen in markets in recent years.
In equities, as the demand for yield wanes and wage pressures build, capital expenditure is likely to replace share buy backs and higher dividend. This feeds back into stronger growth and rising inflation expectations and more capital expenditure.
If these variables persist they are likely to lead to a return to more normal economic growth rates.
The path to reflation
Until recently, markets have been concerned about deflation. That changed when the new US administration was elected.
President Trump’s election triggered substantial moves in global share markets. Deflation fears were suddenly replaced with the notion reflation might be returning. Markets were even concerned about rising inflation.
At the time bond yields soared, the global yield curve steepened, the price of bank and financial stocks rose and the ‘great rotation’ out of equities and into bonds once again became a hot topic. But that didn’t last long.
Bond yields peaked in late December, the performance of financial services stocks plateaued soon after, inflation expectations fell sharply and the global yield curve flattened.
So buying into the reflation theme – based on post-election market moves, news and hype – may have been a huge mistake.
Taking a step back and looking at the market and macro developments from a distance would have shown the reflation trade wasn’t really underpinned by large, fiscal spending plans.
In fact, it was a theme backed by three factors. The first was the peak for monetary policy divergence between the US and other economies like Europe, Japan and China. The second was fiscal neutrality following years of fiscal austerity, falling short of aggressive fiscal expansion. The final factor was the most positive global growth profile in seven years.
By early 2017 markets had priced in an immediate and effective delivery of a large fiscal spending plan by new US administration and a V-shaped recovery in inflation.
In reality, this was a highly unlikely scenario with plenty of room for disappointment.
In light of this environment, AMP Capital reduced its exposure to more cyclical assets such as global energy as well as investments exposed to the reflation theme such as global banks.
Planning for risks
Rising geopolitical tensions, especially events in North Korea, are also contributing to a re-think by investors. These events tend to prompt investors to flock to relatively less risky assets such as gold, government bonds and traditional safe-haven currencies such as the Japanese yen.
Moving from geopolitics to politics, the upcoming French election is a source of market concern. SMSF investors should be aware AMP Capital’s funds have hedging in place so that assets are protected in the event of political unrest in Europe.
High growth in Asia is another reason to believe global economic growth will continue to rise. China’s growth is accelerating for the first time in seven years with less reliance on credit. There has been a sharp contraction in the gap between nominal GDP growth and credit growth. In the past this gap has called into question the sustainability in China’s growth. So higher Chinese growth is welcome, if it is sustainable.
So although markets may have unwound the so-called ‘Trump trade’, global reflation continues. Asia and specifically China remain at the forefront of this global recovery, which is broad enough to be a driver in the reflation contagion across the world.
Moreover, in April the International Monetary Fund posted its first upward revision to the world economic growth outlook since April 2011. While the revision was only from 3.5% to 3.4%, if this trend continues it could mark the end of the post-GFC global growth slump.
In summary, despite the reversal in the post-US election surge in risk appetite, as well as other risks, the global economy is still strengthening, largely thanks to strength in the Chinese and other Asian economies.
This is the view AMP Capital is using to shape asset allocations in the Dynamic Markets Fund. In the second part of this article series we will assess how this view is expressed in the portfolio.
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