What’s set to shape markets in 2018

March 26, 2018

The global economic climate offers plenty of opportunities and poses many challenges for investors. An end to economic stimulus, the continuing rise of populist politics and ongoing environmental pressures are a few big issues shaping markets.

 

Banks tighten their purse strings

After almost a decade of increased spending and low interest rates, the world’s central banks have started to pull back from efforts that stimulate their local economies.

In response to low unemployment and strong economic growth the US Federal Reserve (the Fed) announced plans to gradually “normalise its balance sheet” over the coming years; reducing purchases of US treasuries and government-supported securities.

In November 2017, the Bank of England announced its first rate hike in a decade and this year the European Central Bank started buying less assets. The pace and scale of the shift from “quantitative easing” to “quantitative tightening” will be critically important for markets in 2018 and beyond so it doesn’t strangle consumer and investor confidence.

In fact, monetary policy poses the single biggest risk to almost all financial markets; if the Fed and other central banks raise interest rates aggressively in response to higher inflation economies and equity markets could be undermined.

 

February correction a case-in-point

Recent market volatility, which saw the S&P 500 Index fall by 4.5% in a day and essentially reversed share market gains for January 2018 before bouncing back, is evidence of how touchy markets are to interest rates.

The apparent source of the sell-off in early February was a US jobs report which showed stronger-than-expected wages and employment growth. That raised expectations that bond yields will increase faster-than-expected and prompted fears the Fed would raise interest rates.

The volatility index (VIX), which is known as ‘the fear gauge of Wall Street’, briefly touched 50 on Monday 5 February, its highest level since the Chinese currency devaluation of August 2015.

That’s because low rates have been a key ongoing support for the share rally that began in 2009; so even an inkling of rate hikes can lead to fear about falling share prices. In a classic market over-reaction, perception became reality and prices dropped – for a couple of days at least.

A 4.5% drop is not extreme in percentage terms; historically markets experience similar falls every two years or so. It was really quite jarring due to the extended period of extreme calm leading up to it.

 

Backlash against mainstream politics  

Investors are likely to face an environment of heightened political uncertainty for some time.

Since the early 1980s there has been widespread adoption of neoliberal policies, broadly centred on free trade, free markets and reduced state regulation.

In recent years though, there’s been a backlash against mainstream politicians and their neoliberal policies, largely attributed to high levels of immigration, rising inequality and stagnant wages in many developed economies over the last 30 years.

The Brexit vote, elections across Europe, Donald Trump’s US Presidency, the Catalan bid for independence and more recently an undercurrent of support for Berlusconi’s return to public office in Italy are all examples of the rise of populism. These political developments come at a time of weak global trade and therefore pose the risk of increasing isolationism, protectionist trade policies and currency volatility.

We expect the current economic strength to continue into 2018, but investors should start preparing their portfolios for the risks of sudden falls in asset prices. It can be a good idea for investors to speak to their financial adviser about stress-testing their portfolios against large movements in equity, bond and currency markets.

 

Environment and sustainability

Increasing numbers of investors will seek to reflect their values and to promote the social good.

Climate change remains one of the most pressing environmental issues for investors, both as a physical risk to real assets and as a policy risk to a wide range of carbon-sensitive assets.

There has been a clear trend in recognising the importance of Environmental, Sustainability and Governance (ESG) issues in the investment industry and as a result, institutional investors are now duty-bound to consider environmental risks such as climate change while making investments.

We see this as a positive development, having explicitly stated for many years that an engaged and sustainable investment approach – one that takes a long- term perspective and recognises the importance of ESG issues – is likely to preserve long-term investment capital.

Investors should review their portfolio objectives and risk appetite with their Mercer Financial Adviser against how exposed they are to carbon-intensive assets and how they may be affected by policy developments like carbon pricing or a carbon tax.

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