Going into 2018, further tightening and a close look at the nation’s balance sheets is widely expected by many investors.
John Vail, chief global strategist at Nikko Asset Management, predicted the three US Fed rate hikes last year as well as its plan to reduce its balance sheet. He anticipates four further hikes in 2018.
“We now expect 25 bps hikes in each quarter of 2018, which is well above what fixed income markets and economists expect,” he says.
“For this call, it is noteworthy that two hawks are replacing two doves as FOMC voters in 2018. The ECB and BoJ have remained very dovish, as we have long predicted (along with consensus), but we expect them to be significantly less dovish in 2018 than the market expects.
“Investors must brace themselves to take higher potential risks for lower expected returns."
“The ECB will start QE tapering in January, as expected, but its rhetoric will likely be much less dovish and it should indicate in the third quarter that it will hike rates by year-end, whereas the market only expects this to happen in 2019.”
Any sharp or unexpected changes in monetary policy could upset markets, Richard Stammers of European Wealth warns.
Stammers, investment strategist at the wealth firm, expects policy to remain relaxed but adds he remains cautiously optimistic as the New Year begins.
“Central banks could tighten further in 2018 but, so far, have been measured in addressing how to unwind their balance sheets,” Stammers says. “However, sharper and faster than expected increases in interest rates are a real risk and some camps believe the market has underestimated just how fast the Federal Reserve will move when the time inevitably comes.”
As a result, Stammers remains “wary” of anything other than “very short-dated and very high quality bonds”.
“Investors must brace themselves to take higher potential risks for lower expected returns. In this environment, we find ourselves urging a degree of prudence and care in order to minimise the impact of any nasty shocks,” he adds.
Psigma’s investment team has been similarly stuck on which area of fixed interest to invest in given the “barren” landscape of viable options.
“To be clear, the opportunity to find investments to make us salivate, as we could in 2009, 2011 and 2016, has now mostly passed,” the team said in a recent outlook.
“In particular, fixed interest markets around the world have become increasingly barren and we are forced to work incredibly hard and think ‘outside the box’ to find attractive investments in bond markets from a risk/reward perspective.”
Thinking outside the box
In a reflection of Stammers’ suggestion that investors may have to go up the risk scale to secure returns, the Psigma team has found opportunity in credit investments such as US mortgage-backed securities, European asset-backed securities and “some corporate credit investments, particularly in the UK where there is a ‘Brexit’ premium”, it said.
“These investments should be less sensitive to rising interest rates and should also continue to benefit from a solid global economic backdrop.
It added: “After two years of outsized gains, we still expect positive performance but undoubtedly some of the outstanding ‘recovery’ returns we envisaged from the miserable investment environment of late 2015 and early 2016 have been realised.”
Overall, the “delicate dance” of loosening monetary policy while global inflation remains stubbornly low looks set to continue, according to Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers, who believes central banks will remain the key determinant of risk asset prices in 2018.
“The task of balancing growth, inflation and stability concerns while not creating shock waves in markets should be simpler provided inflation remains subdued. With modest inflation rates, central banks can afford to take their time in recalibrating their policies, and the importance of financial stability concerns in central banks’ objective functions can rise gradually,” he says.