The first two months of 2016 were challenging times. Global risk assets, especially commodities, were in a free fall and the market was pricing in a global recession and possible hard landing in China. Compared to 2016, the 2017 financial market is having a great start, with all major risk assets performing well year-to-date. The S&P 500 Index has not seen a 1% drop in over 90 trading days, and 3-month realized volatility has not been this low since 1995.
There are mainly two fundamental drivers behind the rally. First is the global economy. We are seeing a pickup in growth in the U.S., Europe and Japan, and China is stabilizing after a big stimulus in 2016. The risk of recession, or deflation, is off the table now. The other driver is the expected pro-growth policies from the new administration. The market is expecting less regulation, lower tax rates and fiscal stimulus.
When we look at market movements, we like to see all markets sending the same message and confirming each other. At this moment, the yield curve is showing some doubts. The 10-year Treasury yield is flat year-to-date and has flattened almost 30 basis points (bps) since the middle of November. If the bond market thinks we are getting faster growth and higher inflation, as the equity market is telling us, the yield curve should not flatten.
Another thing that keeps me cautious of this risk rally is the political environment. Domestically, the market is celebrating because we have a pro-growth president. However, being pro-growth is the means to the end of being pro-jobs. Higher growth helps to create jobs and raise wages, but trade tariff and protectionism can help in the short term as well. What will the market reaction be if we see some of this play out?
Globally, we are seeing the insurgence of the forgotten men and women. In Denmark, we have the anti-Islam, far right leader of the Dutch Party for Freedom (PVV) leading in the polls ahead of the election in March. In France, Marine Le Pen, the anti-immigrant, Eurosceptic, far right leader of France’s National Front (FN) is gaining in polls heading into the presidential election in April. Even in Germany, where Angela Merkel is expected to win the re-election easily, the far-right party Alternative for Germany (AfD) has emerged. We have never seen this many populist parties move to the mainstream in the western world in recent history. Will they get the chance to govern? How will policies change? This will slowly play out in the next few years.
Last year, I wrote about the cheap valuation for inflation hedges. When I look at the market now, it is hard to see anything attractive. However, high valuation does not mean the markets will go down. Bull markets tend to go longer than expected, much to my chagrin. What differentiated this cycle from the past two cycles is that even though the financial asset is richly valued, there is no obvious excess in the economy. Unlike the housing bubble in 2008 and the tech bubble in 2000, there is no area of the economy to point to an excess of investments and hiring. The corporations mostly accepted the slower growth in revenue and use profits for dividends and share buybacks.
This lack of excess probably means this recovery can last longer. So most likely, the markets will be quiet and slowly grinding higher. The future real return of risk assets should be low because of current high valuations. However, the nominal return can be more volatile depending on the future inflation. Because of the heightened inflation risk, equities are looking relatively more attractive than bonds.Key Takeaway:
There are not a lot of bargains to be found in financial assets. It is also hard to see a catalyst to break current market dynamics. Stay patient, stay diversified, and don’t chase the rally. Wait for opportunities. Watch the yield curve for clues about how the market is anticipating and digesting the rate hikes from the Federal Reserve.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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