The major central banks left monetary policy unchanged in their first meetings of 2017, maintaining a supportive environment for equities and other riskier assets.
Despite Brexit and Donald Trump’s protectionist policies dominating the headlines since the start of the year, and the associated political uncertainty, stock markets have extended last year’s gains, economic data has been encouraging and fears of deflation have faded.
As we highlighted in a recent Insights article, Goldilocks Returns, moderate price rises are welcome news for a global economy that has already started the year in relatively good health and where conditions are not too hot or cold. In other words, low but rising inflation allows central banks to leave rates low or only raise them gradually – market-friendly monetary policies that can help sustain steady economic growth.
With central banks keeping a steady hand on monetary policy, an environment of low interest rates and inflation should be good for global growth
The European Central Bank (ECB) held its first meeting of the year on 19 January, and kept its main interest rate unchanged at zero, as expected. Policymakers said deflation risks have disappeared and the region’s economy has been gaining strength although the recovery remains fragile. The ECB also confirmed its stimulus programme of regular bond buying will continue and could increase if required.
THE INFLATION DILEMMA
At the beginning of February central banks in the UK and US also announced they would be leaving rates unchanged for now. While rising inflation could present a dilemma for the Bank of England, policy makers also left their forecast for inflation over the next two years unchanged in their latest inflation report. We expect UK rates to stay on hold over the course of this year, though they may move up earlier if the bank deems it necessary to combat rising inflation.
Future interest rate decisions may move up or down as the Bank of England strikes a balance between supporting growth and managing inflation
UK consumer prices rose at an annual rate of 1.6% in December, the fastest pace for two years. One of the main causes was the weakness in the value of the pound, which has pushed up the cost of imported goods. Rising fuel costs have also contributed. Yet we believe price pressures from energy and weak sterling will prove largely temporary.
The BoE will also want to remain cautious owing to uncertainty surrounding Brexit. Prime Minister Theresa May has said she will not provide a running commentary on the process and reiterated her position that Britain’s exit from the European Union will be a clean break. The high and rising level of household debt has also been highlighted as a potential risk to growth.
With the US economy within the range of what the Federal Reserve (Fed) considers full employment and inflation also heading towards its 2% target, average projections from Fed officials point to two rate rises this year, with some expecting a third hike before year end. Meanwhile, President Trump has yet to clarify his economic policies, and the world is waiting to find out just how many of his promises will come to fruition.
As we respond to the evolving investment landscape, our principles of being patient, long-term investors and looking for value continue to lead us to prefer equities and other risk assets over expensive government bonds. We believe the longer-term return prospects for government bonds are poor, while below-inflation yields in many cases erodes their real (inflation-adjusted) value over time.
Stock markets largely shrugged off concerns over Brexit and the US election result last year, with the S&P 500 and FTSE 100 pushing on to new record highs in the first few weeks of 2017. In contrast, with interest rates set to rise further in the US and expectations of higher inflation, the long-term return prospects for government bonds have deteriorated further.
In response, our investment principles of diversification and looking for long-term value have led us to seek sources of returns that are uncorrelated with equities and other riskier assets, while less sensitive than government bonds to rising inflation and rates. We have added three funds recently in a typical balanced portfolio.
First, BMO Global Equity Market Neutral Fund, which seeks to generate a positive return through most market conditions. Second, Nomura Momentum G3 Index fund, which invests in trend-following strategies across interest rates, foreign exchange rates, equities and commodities. Lastly, the JP Morgan Global Macro Fund seeks to generate a return above interest rates over the medium term by investing across a broad range of asset classes.
These alternative strategies can provide similar diversification benefits to government bonds in multi-asset portfolios as well as having better prospects in our view for positive longer-term returns.