For the next 6 months, invest for higher rates, expect protectionism to worsen
Global growth in the first half of the year has been somewhat weaker than expected. We saw growth slowing much more than we anticipated, the US dollar weakening, bond yields falling.
In the second half of 2017, we anticipate a moderate global growth, albeit at a slightly slower pace than that registered in the first half.
Somewhat perplexingly, global inflation dynamics continue to print below consensus estimates, but we see this weakness as temporary and believe major central banks will start to normalise monetary policy over the course of the next two years.
In emerging markets, we note economic activity is softening slightly, particularly in Asia. Importantly, we expect China’s growth to moderate in the third quarter, following two upbeat quarters, not least due to spillovers from recent regulatory and monetary tightening measures.
The financial markets mirror this generally positive backdrop, with equities off to a solid start to the year. But as global growth synchronises, markets are starting to worry about higher interest rates with fixed income markets around the world flashing warning signs in the form of sharply higher long term bond yields.
For now though, earnings rather than expectations of future interest rates will likely guide equities. But the problem is that the growth expectations in per-share earnings over the next 12 months remain too optimistic, in our view. Additionally, valuations have become expensive since the rally and technical indicators have turned neutral, but low volatility and ample liquidity remain supportive. Overall, with macro momentum slowing and the US Federal Reserve on a tightening path, equities are likely to consolidate at current levels.
In the fixed income space, initially, decelerating economic momentum and mixed risk sentiment (especially in commodities) guided bond yields lower in the first half of the year.
This move has started to reverse, rightly, as the markets start to buy into the Fed’s expectations that the “weak growth patch” will soon pass and that a tight labour market will eventually see rising price pressures alongside wages growth.
In a rising yield environment, keep durations short in the US dollar-denominated bonds, with 1-3 year investment grade corporate bonds offering the best risk-reward ratio. In euro-denominated bonds, we continue to favour financials, with insurance subordinated debt still our preferred segment.
In the exchange rate space, we anticipate the US dollar to strengthen against the euro on support from above-average rate spreads and tightening US monetary policy.
A key risk to our positive dollar view is continuously soft US data, which could derail the Fed from its hiking path, as well as renewed political uncertainty in the USA.
We still see the Japanese yen as the best vehicle to hedge against not just global risks but also any dovish Fed surprises. The yen benefits from safe-haven characteristics, tends to react more strongly to changes in Fed expectations than the euro and is more cheaply valued.
In commodities, we have a positive view on oil and a negative view on gold. For oil, speculative positioning is now much lighter and the extension of supply cuts by the Organisation of Petroleum Exporting Countries (Opec) should accelerate the inventory normalisation process, especially during the summer season.
We see tactical upside in the oil price to the mid-US$50s per barrel, but note that uncertainties loom in 2018. Gold and silver remain heavily dependent on investor flows as demand in the primary market is muted.
In light of our macro view, our investment recommendations for the second half of 2017 are straightforward. Most importantly, invest for rising interest rates, including floating rate notes, investment-grade bonds of short duration, and other income-oriented investments offering resilient and/or rising income streams.
Anticipate a rise in protectionism. Years of hyper globalisation helped reduce inequalities across countries but raised inequalities within countries, leading to the social disenchantment that is now driving political change in many Western countries.
Looking ahead, we expect a period characterised by economic policy that seeks to support domestic consumers and redistribute growth to sectors with high domestic employment. This will likely shift the spotlight to national champions and brands, defence and security and emerging market consumers, areas we consider multi-year investment themes.
Technology at the service of humans is set to remain a key investment topic in the years to come. Digitalization paves the way for innovation, with internet platform companies and firms offering virtual reality and augmented reality technologies among the main beneficiaries. The sheer amount of data that continues to grow strongly will result in opportunities for cyber security and data waste management. This revolution will benefit vendors of semiconductors and robots.
John Woods is Chief Investment Officer, Asia Pacific at Credit Suisse.