It now looks very likely that the Fed will raise interest rates again. There is a very high degree of forecaster and financial market consensus that the fed funds rate will be raised by 0.25% at the Fed’s December meeting. Ongoing growth in the U.S. economy and gradually higher inflation suggest that bond yields are also heading higher, with the latest (November) forecasts from the Wall Street Journal’s panel of forecasters picking a rise in the 10-year Treasury yield to 3.0% by the end of next year and to 3.3% by the end of 2019.

It now looks very likely that the Fed will raise interest rates again. There is a very high degree of forecaster and financial market consensus that the fed funds rate will be raised by 0.25% at the Fed’s December meeting. Ongoing growth in the U.S. economy and gradually higher inflation suggest that bond yields are also heading higher, with the latest (November) forecasts from the Wall Street Journal’s panel of forecasters picking a rise in the 10-year Treasury yield to 3.0% by the end of next year and to 3.3% by the end of 2019.
Interest rates are also heading higher in the U.K. As expected, the Bank of England raised its policy rate (’bank rate’) by 0.25% to 0.5%. The bank will be taking a very careful approach to any further increases, which is understandable given very large Brexit uncertainties. Unlike the Fed it is not yet prepared to start running down its stock of bonds (purchased to keep yields low) and it emphasized that “All members [of its policy committee] agree that any future increases in Bank Rate would be expected to be at a gradual pace and to a limited extent.” But as in the U.S. the tide has turned on the era of ultra-easy monetary policy.

The European Central Bank is also heading in the same direction, but even more cautiously. The most it is currently prepared to do (as it announced after its October 26 policy meeting) is to scale back how quickly its bond stockpile will grow (from net purchases of EUR 60 billion a month to EUR 30 billion, starting next January). But it too is gradually beginning to move away from peak monetary ease. Only in Japan is policy likely to remain on an ultra-supportive setting for the indefinite future.

The likelihood is that global bond yields in aggregate are on the rise, making the outlook challenging for the asset class. Fund managers continue to be wary. In the latest (November) Bank of America Merrill Lynch (BAML) survey of fund managers, 77% expect world interest rates to rise over the coming year (only 5% think they will fall). As a result, they remain very heavily underweight to the asset class: A net 56% are underweight, which is the level you get when 73% are underweight and only 27% are overweight. And “a crash in global bond markets” was rated the second-highest risk that worried the fund managers. While all sectors of the bond markets are likely to feel some pain, the higher risk end, which was disproportionately bid up in price during the era of the “hunt for yield”, looks especially vulnerable.

International Equities — Outlook

The economic outlook continues to be broadly supportive for global equities. Most focus, particularly given the high valuations of American equities, is on the outlook for the U.S. economy.

While the data have been knocked about by the impact of hurricanes, the latest indicators have been good. The September quarter GDP came in at a stronger-than expected 3.0% annual rate. The jobs numbers have also been solid, with 261,000 more jobs in November, and a fall in the unemployment rate from 4.2% to 4.1%.

More widely, the pace of business activity in the overall global economy appears to be accelerating. It has helped that two of the more mediocre economic performers of recent years, the eurozone and Japan, are both—at least cyclically—on the mend. On the latest (September quarter) data, for example, Japan has now managed to achieve seven straight quarters of GDP growth for the first time since the turn of the century. In the eurozone, the latest (September) GDP numbers show that the European Union grew by a respectable 2.6% over the past year, a clear pickup from its 2.0% growth rate a year ago.

As the latest IHS Markit Global Business Outlook says, in October “Worldwide confidence towards the 12-month outlook for business activity is running at its highest for just over three years.” For investors, the key issue is whether the pickup will flow though to corporate profits, and the Outlook suggests it will: “With demand conditions predicted to strengthen and higher cost burdens projected to be shared with clients, profitability is expected to improve especially solidly in the euro area, the U.S., Russia and Brazil.”

The key challenge for the asset class remains expensive valuations, particularly in the U.S., and excessive complacency about potential risks and surprises. The latest BAML global fund manager survey found that the managers also expect a supportive world economy: over half of them expect growth at a faster than usual pace, and with lower than usual inflation. Some optimism is therefore clearly justified. But BAML pulled no punches about overly gung-ho investor sentiment. It said that “investors' risk taking has hit an all-time high. A record-high percentage of investors say equities are overvalued, yet cash levels are simultaneously falling, an indicator of irrational exuberance.”

To some extent fund managers are trying to deal with valuations and risk by aggressive regional and sectoral tactical allocations. In the BAML survey managers are heavily overweight to the eurozone and to emerging markets, and solidly overweight to Japan, while running a substantial underweight in the more expensive U.S. They are also heavily underweight to the U.K. as a way of managing the uncertainties of Brexit. But these regional bandwagon allocations—and some similar sectoral ones, notably high allocations to tech stocks, which survey respondents felt was now the “most crowded” trade—have their own risks if adverse surprises mean that everyone is trying to get through the same exit door at the same time.

Risk also continues to be underappreciated. In the last few days one of the bellwether indicators of investor anxiety—the level of volatility expected from the S&P 500, as measured by the VIX Index—has picked up a little. It is currently 13.1, but it is still well short of its long-run average of about 20, suggesting the outlook is seen as substantially less risky than usual.

This is rather surprising, given for example that geopolitical tension has been particularly intense over North Korea’s nuclear missile programme, and that there is a wide range of other geopolitical or economic risks that might materialise. On the economic front alone, the Trump administration’s tax plans may not make it through Congress, against investors’ current expectations that they will. Central banks could make a mistake with their gradual tightening of monetary policy (the top risk identified by the BAML respondents). China’s growth could falter (it has already been the factor behind recent falls in commodity prices).

To date, investors have been generously rewarded for taking the view that all would turn out well, and it is helpful that the latest global economic data provide further support for holding risk assets. But it is likely that coming months will see investors’ insouciance around risks tested more vigorously.

Performance periods unless otherwise stated generally refer to periods ended November 15, 2017

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation.

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