IN BRIEF

  • The macro environment in 2017 provided fertile ground for most asset markets. The recovery strengthened by sector and geography, and while deflation risks receded, inflation failed to accelerate enough to spoil the party. Central banks committed to maintain accommodative policy for the foreseeable future pleasing equity and bond investors alike. The question on most investors’ minds is: “is this too good to last?”
  • We find little cause for imminent concern. The recovery may be “old,” but there is still scope for the expansion to broaden both through Europe and the emerging world. If anything, macroeconomic risks are receding and there is even upside potential if productivity starts to pick up alongside trade and investment. Even in the US, where the cycle is more mature, the leading indicators remain strong and point to robust corporate earnings.
  • While the Federal Reserve (Fed) will continue to slowly lift the Fed funds rate higher, longer-term rates are likely to be constrained by ongoing accommodative policy at both the European Central Bank (ECB) and Bank of Japan (BoJ). Do not underestimate the impact of the BoJ’s extraordinary commitment to fix its 10-year government bond yield at 0%. Forget “don’t fight the Fed”; it is the BoJ we will be keeping an eye on.
  • Overall, we are more concerned that this “Goldilocks” expansion becomes “too hot,” rather than “too cold,” in 2018. We see little reason to shift out of a portfolio skewed towards risk assets. Given everything seems expensive, we still prefer equities over credit over government bonds. Cash is expected to produce a negative real return for yet another year.
  • There are still things to be wary of. In particular, no one knows for sure whether inflation is dead or merely sleeping. Similarly, central banks could get tetchier about whether they are repeating the errors of the 2000s. A punchier uptick in inflation and/or more hawkish central banks would result in significant market moves. To insure against such shifts, investors should think not just about the diversification, but also the liquidity of their portfolio. It might also be worth building positions in assets less vulnerable to inflation and higher yields, such as financials and value sectors over growth. After a period of exceptionally low volatility, a more nimble approach to asset management may well be required this year.

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