Tuesday 13th December
Market moves have been dramatic since Donald Trump’s surprise election victory on 8 November. Markets are expecting Mr Trump and the Republican majorities in Congress to deliver personal and corporate tax cuts, coupled with at least some increase in infrastructure spending. This is driving up forecasts for US growth and inflation, and in turn supporting US equities, the dollar, and interest rates – a ‘reflation trade’ after years of sluggish growth and deflationary pressure following the global financial crisis. Observers with longer memories recall the first Reagan administration in the 1980s, when tax cuts and defence spending boosted the deficit, helped keep interest rates higher, and strengthened the dollar, while the stock market boomed.
However, in our view we shouldn’t exaggerate the ‘Trump effect’. Scottish Widows’ analysis is that developments broadly reflect trends we had identified were in place before the US elections. The low point for bond yields was back in July (for the US) or August (for the UK); yields started rising when markets still widely expected Mrs Clinton to win. The dollar began its recent strengthening phase in May.
Market moves reflect a growing expectation that the US and global economies are finally approaching a sustainable lift-off where growth is fast enough for the risk of inflation to outweigh the risk of a relapse into deflation. This shift pre-dates Mr Trump’s victory, although his election has helped to crystallise sentiment and reinforce it.
A year ago, there was serious talk of a potential need for emergency monetary policy support such as ‘helicopter money’ (deficit spending financed by money creation), which depressed interest rates. Concerns over China’s stability were building as its economy slowed. The UK’s surprise vote for Brexit in June further rattled confidence. However, markets’ perceptions of macro fundamentals have since shifted back to a more optimistic frame for all the main global economies. Even the hit to the UK from Brexit seems to be less than most forecasters originally feared.
We remain focused on the risks to these trends and the risk of the market overreacting. As a UK-based investor, we continue to monitor closely how the Brexit process is playing out. UK economic data so far have surprised most economists on the positive side. The Bank of England has signalled there are limits to its toleration of higher inflation, implying at least a risk of higher UK interest rates sooner than the market’s expectation of late 2018/early 2019. Nonetheless, the risk remains that weaker real wage growth or business confidence could hit demand more than currently expected and see the Bank revert to easing policy, which could see yields fall rather than rise.
On a global level, emerging market assets have performed relatively poorly since Trump’s victory. President-elect Trump has backed away from the protectionist rhetoric he adopted on the campaign trail, although the chance of new trade deals such as the Trans-Pacific Partnership seems almost zero. Again, we think the real issues are more fundamental. Returning to the 1980s, the strong US dollar and high interest rates helped to cause a wave of debt crises in emerging markets. Today, a number of emerging markets have a hangover from the surge in dollar borrowing by their corporate sectors. China’s corporate sector has been clearing its dollar debt, but China’s domestic debt level is huge. Still, a 1980s re-run is far from guaranteed; many emerging markets have strengthened their economic fundamentals. The risks also have to be balanced against the relative cheapness of emerging markets’ assets, particularly equities.
The other key global risk remains the integrity of the eurozone, some five years after the bloc’s sovereign debt crisis erupted. The region faces a run of political risk events in the wake of the fall of the Italian government over its referendum proposal on 4 December. Political consensus for fundamental reforms to address the bloc’s economic imbalances seems to remain lacking. However, experience of the eurozone crisis in 2011-12 teaches that political will to sustain the eurozone is strong, and we think a break-up remains a remote prospect.
The shift from deflation to reflation could make 2017 the year of the most substantial change in market regime since the global financial crisis – and major policy change allied to geopolitical uncertainty is a challenging environment. Our analysis of the global reflation theme linked to these wider issues informs our positioning across our funds. More broadly, we believe a diversified multi-asset approach, as reflected in multi-asset funds such as the Scottish Widows Premier funds, makes sense in an environment of uncertainty.
Investment markets and conditions can change rapidly and, as such, the views expressed in this update should not be taken as statements of fact nor be relied on when making investment decisions. Forecasts are opinions only, cannot be guaranteed and should not be relied on when making investment decisions.