Strategy: Risk-on rocks on despite tighter financial conditions

12 Dec 2016

  • Economic data surprises positively…
  • …but it is not universally strong
  • Fed rate rise baked in, but what is the official outlook for the fed funds rate?
  • Extremely simulative monetary policy seen slipping into the second place
  • Maintaining our cautious asset allocation

Financial markets have remained firmly in risk-on mode. US equities have made further gains, while European equities have now joined in the uptrend. Japanese equities have rallied in tandem with a weakening yen. Bond yields are still rising and risk spreads are narrowing. Sure, economic data has surprised positively, but it is interesting to see how well equities are able to cope with tighter financial conditions and rising oil prices.


Economic data points to improving growth momentum. Reflecting performance compared to market expectations, growth surprise indices have gained in the US, the eurozone and Japan. Thus, the data has quite consistently beaten forecasts. Of course it could be that economists have been overly downbeat, but we do not think so. From here economic surprise indices are most likely to become less buoyant, but we expect this to be driven by brighter data forecasts.

US jobs data continued to show a fairly dynamic labour market, but also one that is close to full employment (and thus the Federal Reserve’s target). Job openings, job hires and voluntary job quits have all plateaued this year. Companies are also reluctant to lay off workers as a tight labour market makes it more difficult to find new employees, if needed.

Labour market strength and strong equity markets are positive for consumer confidence to close to its post-recession peak set in January 2015. Real disposable incomes are growing solidly and household net worth posted a robust gain in the third quarter.

On a global basis, the severe weakness in global trade in the first half of the year has ended. Taiwanese annual export growth has turned from sharply negative to strongly positive since the start of the year. Export growth has also turned positive in South Korea and marginally so in China for the first gain in 16 months.



While recent data has been surprisingly positive, we do not see universal strength. October was not a strong month for the industrial sector. The growth differential between emerging markets and industrialised countries has ticked up by a notch. Fortunately the purchasing managers indices point to some acceleration, more so in developed economies than in emerging markets.

In Japan, GDP growth for the third quarter was revised down materially from 2.2% QoQ annualised to 1.3%. Machine orders pointed to continued sluggishness in business investment. The Economy Watchers’ Survey index has stopped out at a relatively modest level.

In Australia, GDP surprisingly shrank in the third quarter. The previous time this happened was in the first quarter of 2011; the last technical recession was in the first half of 1991. The decline was due to temporary factors such as a contraction in government spending, bad weather affecting residential construction and disruptions in coal mining affecting exports. Stronger commodity prices should be supportive. So the economy should be able to continue its long run without a recession. However, stretched housing markets, a wobbly labour market, mining providing less support and low inflation may keep the discussions about monetary easing alive.

In China, foreign exchange reserves fell despite a sizeable trade surplus. Capital outflows seem to be on the rise again. Outflows and a weaker currency have caused market unrest in the past, but this has been ignored so far this time. To some extent the latest outflows are more worrying as they are less related to paying down Chinese-owned US dollar debt.



We reported[1] on the ECB’s decision to slow the pace of its asset purchases after next March. We think it struck a clever balance between a slower pace and a longer extension of the asset buying programme than expected. For the ECB, this year’s increase had basically been an emergency measure against a material risk of deflation at the time. This is no longer present.

In the US, looking at market expectations, a rate rise on 14 December appears to be a near-certainty. The economy has been strong enough and the Fed is close to its targets for employment and inflation. The most interesting part to watch for is whether policymakers will increase their forecasts for the fed funds rate.

In Japan, not much is expected from the central bank meeting of 20 December. But the pace of asset purchases has slowed since the Bank of Japan moved from a target for the volume of asset purchases to a target for 10-year bond yields of 0%. Yields have drifted higher to above the target. The BoJ might tolerate this after the yield differential with US bonds widened, causing the yen to weaken. Past episodes of yen weakness have shown that many companies are saving the windfalls, while consumers have suffered from higher import prices, so there should be a limit to how far the BoJ will allow the yen to slide. Interestingly, the market discussion about the outlook for the BoJ’s policy has shifted from lower to higher rates.

We think the market environment is gradually moving away from extremely simulative monetary policy, either because economies are doing better or because monetary policy is reaching its limits. This is a key theme in our recently published investment outlook for 2017.



As mentioned in the introduction, markets remained in risk-on mode in the past week. Even the rise in oil prices was seen as positive through its impact on the energy sector and through a narrowing risk spread on US high-yield corporate bonds. We think markets should have discounted the prospects of more fiscal stimulus in the US by now, but it could be that investors still want to position themselves for growth in 2017 before the end of the year.

In the US, in particular, we see equities as overvalued. Thus our asset allocation remains relatively cautious.




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[1] Also see