As well as the main referendum (Brexit) and the main election (Trump) in the last six months, there have been partial elections and primaries in several European countries. The overall trend shows a desire for countries to turn in on themselves and for economic stimulus, provided that such programmes deliver practical benefits to the countries concerned and not emerging markets as has been the case in the past. Economists now expect austerity plans to be challenged, including in the most orthodox countries, and we are seeing certain countries adopt new infrastructure development and rearmament plans. That shift could achieve what central banks have been trying in vain to deliver, i.e. a long-awaited return of controlled inflation. However, these policies, with their more protectionist and populist slant, could also cause collateral damage by unleashing inflationary pressures that are harder to manage.
The markets have reacted immediately and sharply, although the reactions have not been what the experts expected. Contrary to expectations, the markets did not fall after Donald Trump's election victory, any more than they did after the Brexit vote. They have welcomed the stimulus policies and tax cuts announced in both the UK and USA. They have responded positively to the shift towards more unapologetically proactive fiscal policies, taking over from sterile monetary policies. In the USA, bond yields have risen sharply all along the curve. Share prices have hit new records and the dollar has started rising again. Safe havens like gold have even suffered a correction, contrary to the expectations of all strategists. There is now the widespread expectation that official interest rates will rise.
Bond yields have increased significantly, producing short-term opportunities on certain dollar-denominated fixed-income securities. However, the result has been a sharp drop in the prices of bonds with long durations, along with wider spreads on lower-quality bonds. We are therefore seeing a resurgence of risk, and this has badly affected portfolios put together in the last few years that contain bonds of dubious quality in some cases. Several recent articles have discussed the shift and how it affects bonds held in investment portfolios (see article in Le Temps on 28/11/2016); they have emphasised the need to rebalance portfolios by investing in equities, in order to avoid even greater corrections in the event of a sharp upturn in inflation expectations.
This turn in the trend and the totally new global political landscape will make it more important to take a more dynamic approach to bond investing and asset allocation, far from the entirely passive, algorithm-driven investing approach recommended by some. Investors with static portfolios are about to rediscover risk, and will have to adopt more active, dynamic and innovative ways of managing their bond investments. It has been a long time since we had to deal with a genuine upturn in bond yields, and it is not something that private and institutional investors expect any more. It will be interesting to see how the return of significant risk levels will affect savings flows given that higher interest rates cause bond prices to fall sharply, which traditionally has a chilling effect on activity in private portfolios.
The first step required in a situation like this is to reallocate portfolios and shift into more defensive bonds, which have been out of favour for many years, particularly TIPS (inflation-linked Treasuries) and floating-rate notes. These types of bonds will give investors a more comfortable ride as the bond market returns to normal, with higher yields across all maturities and a steeper yield curve. Adjusting bond portfolios in this way is clearly a major priority after recent political events.
The promises made by Donald Trump convinced millions of Americans, and the British people voted to leave the EU. The political decisions that flow from those two votes will force all nations and economic zones to look to the future, to show their electorates that they are addressing issues like employment and national sovereignty. These trends represent a challenge to an established order in which austerity policies are the norm and policy is set by central banks. The return of politics will have major consequences, such as economic growth moving out of sync globally and inflation rising sharply. We are seeing a real change in the political paradigm, which may have a larger-than-expected impact on market volatility and portfolio risk. Careful risk management and the reallocation of assets into highly predictable securities, particularly high-quality equities, will therefore be crucial in 2017.
Michel Longhini
CEO Private Banking