Balancing portfolios in an unbalanced world
Investors are constantly challenged to navigate through uncertainty. In the near-to-medium term, asset markets are keenly focused on the path of monetary policy and the potential headwinds that a reversal of unprecedented monetary easing could bring. At the same time, instability in Europe and the potential for a ‘hard landing’ in China cannot be ignored. We remain cautious around the outlook for share markets over the next few years given the macroeconomic backdrop.
Unwinding monetary distortion
G7 central banks have massively expanded their balance sheets and now collectively hold over US$17 trillion of assets – US$12 trillion of which is sovereign debt with negative yields. These unprecedented policy actions have created massive distortions in fixed income markets. These distortions have impacted all risk assets, including shares, by lowering yield and return expectations.
The process of unwinding global monetary stimulus is being led by the US Federal Reserve (Fed). The Fed started this process in October 2014 when it ended quantitative easing, followed by the first hike in US interest rates in December 2015. Macroeconomic conditions in the US are supportive of increases in US interest rates, with inflation expected to move closer to its 2 per cent target. By contrast, the Bank of England and the European Central Bank have maintained their respective quantitative easing actions.
Tightening of monetary policy presents the greatest medium-term risk to asset markets. The unprecedented scale of monetary easing means the impact on share markets from policy reversal could be significant.
Complexities in Europe
The European economy continues to face significant challenges, ranging from political and social issues to systemic risks within the financial sector. The potential for major shocks in Europe presents a risk to world growth and asset markets.
The Brexit vote is likely to result in an extended period of uncertainty in the UK. The path to Brexit and the timing remain uncertain. A ‘hard’ Brexit scenario, where the UK leaves the single market, could trigger a sharp recession in the UK.
Risks of further political destabilisation in Europe are also on the horizon. People of The Netherlands are scheduled to go to the polls in March 2017, followed by the French in April/May and the Germans in September/October, all at a time when there is considerable angst among voters. Growing support for euro-sceptic parties leads to questions around European Union (EU) membership which could potentially destabilise the region. At present, it appears unlikely these parties will prevail in elections, but risks remain.
Systemic risks are centred on the Italian banking system. The country’s book of non-performing loans is over €360 billion, or around 25 per cent of GDP. EU rules on bail outs make government-led bank recapitalisations problematic.
Risks of a hard landing in China
A hard landing in China poses a risk to global growth and could export deflationary pressures throughout the world economy. The key risks to China are the potential for a financial crisis or a rapid run on the renminbi. China has experienced a multi-year credit boom which has facilitated a massive oversupply in the property market. However, China’s financial system is not dependent on external creditors and the central government has the capacity to deal with bad banking debts. Chinese authorities appear to have stabilised capital outflows which makes a collapse in the renminbi appear unlikely. A hard landing or financial crisis spawned out of China appears unlikely at present.
Risks of an exciting future
Macroeconomic drivers are highly relevant for markets over the medium term; however, over the longer term, technological change can have a profound effect on businesses. It is worth reflecting on the differing fortunes of Kodak, Nokia, Google and Apple as contrasting examples of the success and disruption that technological change can bring to individual businesses. We need to question whether we are entering a new technological and machine age over the next 10-25 years that may be more important than the industrial revolution. Prudent investors should keep one eye on central bankers and an even closer eye on how their portfolios are positioned for fundamental and disruptive change over the longer term.
Source: Magellan Asset Management Limited
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