Low returns rule the markets. Governments are warming up to fiscal support. An unusually divisive U.S. presidential election looms large. What should investors expect in the last quarter of the year?
We see upside to global economic growth prospects but also greater market volatility ahead. This comes after a summer lull, record highs for U.S. equities and a rebound in emerging market (EM) assets. We expect the U.S. Federal Reserve to press on with slow interest rate increases while other major central banks start to approach limits of their easy policies.
The Bank of Japan, for example, already owns about 40% of Japanese government bonds (JGBs). At its current pace of buying, it would hold two-thirds of the JGBs by 2020, we estimate, as shown in the chart below. Additional easing measures may have diminishing returns - and unintended consequences.
Pushing the limits
Central bank share of outstanding bonds, 2009-2020
Here are the themes for the fourth quarter:
1 We see early signs of a regime change for market returns due to U.S. reflation and a global pivot from monetary stimulus to fiscal support, even if the immediate economic impact is limited.
2 Our return expectations are at post-crisis lows across asset classes, but we believe investors will be compensated for taking on risk in equities, selected credit, EM and alternative assets.
3 Central bank asset purchases have smothered volatility and pushed investors to take greater risks, but we could see short bursts of heightened volatility as the limits of monetary policy become clearer.
Equity and bond returns are becoming more correlated and could fall in tandem, while rising long-term yields are a tail risk that could cause an unwanted tightening of financial conditions. A divisive U.S. presidential election is the top political risk. Near-term China risks have receded amid a gradual currency depreciation and a pick-up in Asia’s export machine. China’s yuan stability and debt build-up remain medium-term risks, however.
We prefer shorter-duration U.S. government bonds and favor selected eurozone peripheral debt over other sovereigns. We generally like investment grade corporate bonds in the eurozone, UK and U.S. We find EM debt attractive but have become more selective, and we see further upside in EM equities. Dividend stocks may come under pressure from higher bond yields, so we prefer companies that can sustainably grow dividends.