Johanna Kyrklund, Co-Head of Investment and Group CIO at Schroders, reflects on the recent strong run in markets and the many factors that could cause volatility in markets in the year ahead.
After the strong rally in markets into year end, valuations look a bit stretched across asset classes. Our base case is still for a soft landing in the US but this is now very much reflected in the level of equities, credit spreads and the extent of rate cuts priced into the bond market.
The pack of cards needs to be reshuffled to provide fresh opportunities (as you can see, my memories of all the board games I played over Christmas are still dominating my thinking!)
The challenge of course is that markets can move quite quickly - we have elections in 40 countries this year, a tense geopolitical environment and central banks are in the middle of «landing the economy» which can always create volatility.
With cash rates starting to fall, we would advocate being invested. But you need flexible approaches which can navigate these markets for you and take advantage of buying opportunities as they arise. After all, the next card to be dealt can significantly change the hand you hold.
Last quarter, investors were concerned about further rate hikes from the Federal Reserve (Fed) while we were firmly of the opinion that rates had reached a plateau. Well, three months is a long time in the bond markets as we now have a situation where investors are itching to price a Fed pivot.
We are not predicting significant rate cuts given the backdrop of high levels of employment. Although inflation continues to move in the right direction and wage growth has peaked, it feels premature for the Fed to cut so aggressively. As a result, we have closed our long duration positions and favour steepeners to benefit from lower rates.
To the extent that the Fed may choose to emphasise falling inflation rather than tight employment conditions, we would view this as being more bullish for equities than for bonds because we still view the risk of an imminent recession in the US as being low.
More broadly, and in the context of the 3D Reset, the next phase is really to think about what policies emerge from the reset. This is partly a function of the different conditions that each economy faces and the hand of cards that each policymaker has been dealt. As mentioned before in the CIO Lens, this economic divergence is a source of investment opportunity:
- Many emerging market (EM) countries have run more orthodox policies which now leave their debt markets in a good place, with room to ease rates further, leaving us positive on local currency EM debt.
- China faces a deflationary environment as it copes with the ramifications of its property crisis and, although we see some upside to the export cycle, it cannot rely on mercantilism given the size of its economy and the protectionist backlash in the West.
- Japan is still running stimulative policies because of its deflationary history and its high level of government debt might be an obstacle to tightening.
- Europe has a growth problem given an ageing demographic and higher energy costs than its competitors, but it also has a relatively stable political system and its conservative fiscal policies are supportive of European bonds.
- The US has been able to run more stimulative policies because of the dollar’s position as reserve currency of the world. As Reagan once said «I’m not worried about the deficit. It’s big enough to take care of itself». A Trump election might push the patience of investors too far though if it resulted in more fiscal profligacy.
Economics is an art, not a science because of the role of human behaviour. We continue to live in a world that is dealing with the aftermath of the pandemic and is facing unrelenting technological disruption. The 3Ds (demographics, deglobalisation and decarbonisation) have also impacted the relationship between growth and inflation.
Taking all this together, the economic consensus forged over many years is being challenged. We need to fight the tendency to rely on the investment «maps» that served us well over the last decade. Instead we need to focus on the divergences now occurring, and the fresh opportunities these are creating.
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