Global investors are facing extraordinary economic, political and financial market conditions that risk sending the world into a perilous period.
In particular, we are closely watching several key areas of concern, including:
- Rising geopolitical risks and trade tensions;
- Rising populism and political polarisation;
- Unrestrained deficit spending in the developed world;
- Under appreciated inflation pressures in the US; and
- Low policy rates driving investors into riskier assets and thus leading to overvaluations in many parts of the market.
While we see this year as a period of potential uncertainty, we also see significant investment opportunities for investors. We think investors need to prepare for the challenges ahead by focusing on allocations that can provide true diversification against highly correlated risks across the asset classes.
Geopolitical tensions and unorthodox policies remain a concern
There are now acute and contentious clashes over which economic and political paradigms will dominate the next generation: from capitalism to socialism, and from democracy to authoritarianism. The changing power structures between the world’s largest players increase the potential for a geopolitical event, in a range of theatres from trade to military, that could disrupt financial markets.
Recently elevated tensions in the Middle East and frictions between the US and China are two significant examples.
Throughout history, shifts in hegemonic power have often proved very unstable to financial markets and thus merit attention. In addition, there are an increasing number of populist governments, which, in conjunction with a global trend towards extreme polarisation, have stoked greater volatility in economic policy and generally enabled undisciplined economic agendas.
In the US, divisions among the citizens have surpassed any point in recent history and given rise to heightened polarisation between political parties. Economic agendas are now increasingly being justified by largely untested economic theories, such as the Modern Monetary Theory, which advocates for printing money to fund fiscal expansion.
This populist surge has led to rising debt loads and corresponding fiscal risks across the developed world. US deficit spending has deepened significantly, propelling the fiscal deficit towards an annual average of US$1.2 trillion over the next 10 years (4.7% of GDP) and necessitating massive levels of deficit funding through US Treasuries.
Similarly, in Europe, nationalist parties have frayed the fabric of the eurozone, testing the political cohesion necessary to both maintain fiscal discipline today and to hold the coalition together during a crisis in the future.
Extraordinary monetary accommodation continues to distort asset prices
On the central bank front, the US Federal Reserve and the European Central Bank (ECB) were discussing ways to normalise monetary policy as recently as a year ago. However, last year both the Federal Reserve and the ECB again embraced a stance of greater monetary accommodation.
Sustaining this accommodative approach prior to a realised crisis continues to push investors into riskier and less liquid investments.
The world is now flush with more than US$14 trillion in negative-yielding bonds – securities that are designed to return less than nothing. Policies that were once considered highly unconventional have become normalised, as economies become increasingly reliant on central banks to cover gaps in fiscal and economic policy.
The combination of very accommodative central bank policy with a more regulated banking system has amplified credit risk in the shadow banking system. There has been significant growth in US credit markets over the last decade in areas of less transparency – private issuances with limited financial disclosure and diminished debt covenants.
Years of easy money have eroded discipline in the markets by favouring the borrower, thereby damaging the ability of lenders to insist on appropriate financial disclosures and stronger covenants.
All of this can work as long as credit markets remain bullish, but as soon as credit conditions begin to turn, liquidity will come at an exorbitant cost. We continue to remain wary of credit risks and liquidity risks in the global fixed income markets heading into this year and think investors need to prepare accordingly.
Financial market risks warrant attention
The potential for a geopolitical event appears higher than it has been in decades, given ongoing tensions among the major world powers. Additionally, populism and political polarisations are impairing policy decisions, leading to elevated risks for a significant policy error.
Huge deficit spending across the developed world has also exhausted many of the resources to respond to a future financial or economic shock. The heavy reliance on monetary policy tools to cure each minor setback the economy suffers has also blunted the ability for those tools to be effective in an actual crisis.
In short, there is a risk the developed world has overextended itself on both fiscal and monetary fronts, leaving risk assets highly vulnerable to a financial market event.
Given these risks, we see value in certain perceived safe haven assets, which notably include the Japanese yen, Norwegian krone and Swedish krona.
Longer term US Treasuries remain overvalued
Suppressed US Treasury yields appear highly vulnerable to a potential rate shock given rising deficit spending and rising debt, in our view. We believe inflation risks also remain significantly underpriced in markets, given the exceptional tightness in the US labour market stemming from restrictions on immigration and breakdowns in the supply chain.
Additionally, there are risks to the US Federal Reserve’s ability to meet very aggressive market expectations on monetary accommodation that are already priced in across the Treasury yield curve. Rising inflation could put markets in the difficult position of contending with less monetary accommodation than expected.
The Federal Reserve can very effectively control short term rates, but it cannot always control the economic and technical pressures on the longer end of the curve. We expect the US Treasury yield curve to steepen in upcoming quarters as longer-term yields rise. We think investors should consider diversifying against the rate risks loaded in across the asset classes.
Select emerging markets continue to offer value
While we have become more cautious on the broad outlook for emerging markets as a whole, we continue to see scope for additional valuation strength in specific countries and in certain alpha sources. We continue to prefer the risk-adjusted returns in specific areas of the local-currency sovereign bond markets over the more fully valued credit markets.
These opportunities vary highly between countries and across risk exposures – it remains crucial to be selective. Overall, we continue to see a select set of higher-yielding local markets that have the potential to outperform the core fixed income markets in the year ahead.
What are the risks?
All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies.
Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt.
Investments in emerging market countries are subject to all of the risks of foreign investing generally and have additional heightened risks due to a lack of established legal, political, business and social frameworks to support securities markets.
- Hasenstab is executive vice president and chief investment officer at Templeton Global Macro