Asset Allocation

Investment Outlook: 4Q-2016

The Bubble Grows

Risk asset markets have shrugged off Brexit, declining corporate earnings, and even signs of the limits of monetary intervention. And over coming weeks, they could rally even higher.

But this is a bubble, particularly for Developed Market assets. And the risks are growing with each passing week of gains. As we enter 4Q-2016, there are three key risks which have yet to be adequately priced into markets:

  1. Central banks hitting the limits of monetary policy.
  2. A seasonal pick-up in equity market volatility, often seen in the September-November period.
  3. US politics – 8 November is a “live” contest, with Clinton and Trump running neck-to-neck in the opinion polls.

And all this against the backdrop of valuations priced for perfection in Developed Markets.

The US Federal Reserve held off from another rate hike in September, as widely expected. But divisions are widening within the Fed’s policy committee, and Fed communication appears to be guiding towards a hike soon. Yet, markets are pricing in only a 55% probability of a hike in December.

A “secular stagnation” in the US would justify a long-term pause on rates. But that’s not something asset markets should celebrate. And, if the US economy is not stagnating, consumer price inflation will force the Fed to hike in 2017 at a faster pace and more than currently expected. By then, asset valuations and non-financial bank credit would have gone even higher – making the bursting of the bubble even more dangerous.

The Bank of Japan (BOJ) has turned its attention from negative interest rates and quantitative easing to managing the bond yield curve. The BOJ now appears to be “fire-fighting” the unintended consequences of quantitative easing and negative rates. It didn’t drive rates deeper negative because that was hurting banks’ profits. The BOJ also didn’t enlarge its asset purchase programme because it was running out of government bonds to buy.

Historically, there has been a tendency for equity market volatility to rise in SeptemberNovember. Of course, averages being what they are, it doesn’t have to happen every year. However, apart from central bank policy uncertainties, there is something else that could trigger that seasonal tendency this year – US politics.

Opinion polls suggest the 8 November presidential election will likely be a very tight contest. Clinton’s current lead in the polls over Trump is tiny. And with a large number of electoral votes still in play in marginal states, this will be a very difficult election for the markets to call. Meanwhile, Donald Trump’s unorthodox policy ideas and lack of policy details have injected a lot of uncertainty into markets.

But equities – particularly in Developed Markets – are not priced for uncertainties. Indeed, they are priced for perfection in a rather dysfunctional global economy.

Emerging Market and Asia ex-Japan equities are likely to perform better than Developed Market stocks, on relatively cheap valuation and as China continues to stimulate its economy monetarily and fiscally.

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