The macro environment remains supportive of assets geared to growth. Developed markets are leading a synchronized global expansion and financial conditions are easy, with strong equities and accessible credit. That said, we think markets might be complacent and we see inconsistencies that may find equilibrium in the coming months. US sentiment is running ahead of hard data, and rates are too low and financial conditions too loose for the projected policy tightening. We haven’t seen much risk premium to reflect a tapering of quantitative easing (QE), political strains in Europe, or risks in China’s financial sector. While we don’t expect upheaval, we note that the credit cycle is mature, central bank policy is in flux and geopolitical risks are elevated. In a world of stretched valuations, we are currently focused on opportunities in undervalued emerging market currencies.
- The global growth upswing has been synchronized and strong. Our current activity index, which measures the growth signal from major high-frequency indicators, implies global growth is just above 4%. We think momentum is close to peaking, and while the US economy should keep strengthening, we expect more dispersion in global growth due to less accommodative monetary policy, the waning effects of China’s fiscal stimulus and geopolitical concerns.
- We see less symmetry in the global inflation outlook, due in part to dispersion in output gaps. Last quarter (see “Reflation and Rising Rates”) we noted that inflation is picking up, particularly in the US, but core measures remain weak in Europe and Japan. Wage growth is subdued, even where labor markets are tightest in Japan and Germany. We still see value in trades based on divergence in US and European rates.
- The QE unwind is the next challenge for fixed income markets. We believe the scale-back of large asset purchase programs that have suppressed volatility since the crisis poses risks of spillover to credit markets. We see the US Federal Reserve (Fed) taking steps to reduce its holdings of Treasuries and agency mortgages late this year, in line with its broader policy normalization. The European Central Bank (ECB) and Bank of Japan (BoJ) are likely to slow the pace of buying—despite remaining committed to policy easing—due to a scarcity of assets.
- Political risk has increased, centered in Europe. As discussed in our GSAM 2017 Outlook, the rise of nationalist politics poses a threat to the monetary union, irrespective of the outcome of the French elections. By the Italian elections in early 2018, we expect more risk premia in European sovereign debt ex-Germany. Meanwhile, the struggle to repeal the Affordable Care Act raises doubts about the broader pro-growth agenda in the US, and we think markets may be complacent about China’s policy stability ahead of the 19th Congress.
- We favor undervalued emerging market currencies. Solid global growth, a stable trajectory of US interest rates, improved commodities markets and a reduced focus on President Donald Trump’s trade proposals should help some more-volatile currencies rebound. Consistent with our expectation for more inflation and policy tightening in the US, we think US rates will rise, leading to steeper yield curves across major developed markets and weakness in agency mortgage markets.
