Toward normalisation – the uneven path to growth

Compared to other central banks the Fed has made the greatest progress in scaling back the ultra-expansive monetary policy which prevailed for close to a decade. It tapered its bond purchasing programs in 2014 and 2015 and raised the federal funds rate in five steps to a target range of 1.25 -1.5 percent. The European Central Bank plans to maintain its bond purchases at a pace of EUR 30bn a month through September 2018. The decision to end all purchases will depend on whether Eurozone inflation reaches its target of close to 2%. Hiking rates will only be considered after the termination of the bond purchasing program.

When the Fed started QE in response to the global financial crisis after 2008, many investors saw the risk of even greater financial instability down the road. They saw this monetary stimulus as an ill-advised policy which would produce a 'sugar rush' in economic activity and asset prices that would morph into a disaster once the artificial stimulus was withdrawn or even just reduced.

While QE is much better understood today than when it launched, we don't think that all negative side effects can be avoided. It's premature to assess the scale of possible asset bubbles, and the riskiest parts of the market might be where investors have been lured into an overestimation of future returns and an underestimation of the associated risks. The long lasting tailwind of still increasing liquidity at the global level might have seduced some investors to own a portfolio with a risk profile in excess of the one they can and should afford. A desired de-risking of these portfolios might exacerbate technical pressure in correcting markets.

Some pockets of instability might not survive an ordinary unwinding of the stimulus, and in case of peripheral European government bonds an underestimation of the fiscal challenges of some countries might have occurred. The scale of ECB purchases relative to the size of these markets has been so huge that current prices hardly reflect an unbiased assessment of government debt's attractiveness. Effectively as yields continued to fall investors have been even rewarded to become complacent, overconfident and ignoring risks. Anticipating the end of the ECB bond buying program scheduled to run through September 2018 yields might edge up and find their new equilibrium at higher levels.

The Fed’s policy experimentation might be instructive for other countries that followed with lags on the same route. Japan engaged in full-scale monetary stimulus in 2013, five years after the Fed with Europe following suit. The fact that in many emerging economies monetary stimulus and economic recovery picked-up later implies that business cycles and monetary policies are not as synchronised and thus as vulnerable as in past expansion cycles. The drivers of global growth are more broad based geographically and by sector than has been the case in many previous cycles.

That is good news for investors. While the Fed is raising interest rates, Europe will not do so before the end of 2018 and Japan is set to remain accommodative for longer.

However, after a year that was largely free of significant adverse shocks in geopolitics, demand or markets, we believe investors must prepare for the likelihood that their investment journey is unlikely to be as smooth going forward as it has been over the past year. We believe that there is further upside to global equities, but also believe returns from equity markets are likely to be lower than has been the case in recent years.

Against this backdrop, after a protracted period during which beta (the market) has dominated returns, we see a shift toward portfolio manager skills (alpha) playing a much greater role in generating returns. As rates go up, the pace of appreciation of equity markets slows and it is realistic to expect that over a 5 to 10-year period returns will be lower than those experienced over the past few years.

In this phase of the cycle, every 50 basis points of alpha will be worth its weight in gold and the appetite for alpha-oriented strategies is likely to grow.

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