Loose central bank policy, including QE in the UK, Japan and eurozone, has been a key pillar supporting economies and markets for much of 2016. It has provided a firm basis for strong equity market returns in the face of a significant 2015-16 earnings recession.
However, government bonds have sold off sharply over the past three months. US 10-year yields have risen from lows of almost 50bps to 185bps, while bonds have also weakened in Germany, Japan and the UK.
To forecast markets’ performance in 2017, it is crucial to understand whether this reflects a structural change in the market environment or a brief interruption in a continued low-growth, low-inflation world.
Performance of bonds in 2016 in US dollars
Source: FE Analytics
We believe there are two key elements to the change in bond market behaviour.
The first is the prospect of policy change. Central banks in the eurozone and Japan appear to be running out of bonds to buy and the Bank of Japan is more alert to the problems caused by an excessively flat yield curve.
There are also growing global demands for fiscal stimulus to help address deficiencies in economic growth and productivity. The prospects of waning central bank purchases and more government spending are genuine threats to bond markets, even if investors may be wrong in assuming that country-specific issues apply to all main markets.
Bonds have also been sensitive to changing growth and inflation dynamics. Yields reached such low levels that they were sensitive to even the slightest up-tick in inflation expectations.
A rally in the oil price threatened the market’s deflationary mindset and contributed to the sell-off. More inflationary impulses from China, and in the UK from the weaker currency, are likely to exacerbate the dynamic in the shorter term.
The evolution of monetary and fiscal policies will remain a key feature of the investment environment in 2017. This is likely to lead to more volatility and less return from bonds in the early part of the year.
Uncertain growth and inflation dynamics may cause sharp fluctuations but with limited overall upside due to the less conducive policy environment.
Funds following shorter duration strategies should be more rewarding during this period, especially as there is a heightened risk of policy error that creates significant risks and opportunities across all asset classes.
The full year is likely to be defined by whether the reflationary impulse can transition into a genuine, self-sustaining recovery phase that can weather the headwinds of higher US interest rates and any accompanying US dollar strength.
A sustainable recovery would be extremely positive for corporate earnings and value equity funds should benefit significantly. We currently hold exposure to the value style through Legg Mason Royce US Small Cap Opportunity and EDR US Value & Yield, which have already been very positive this year.
Alternatively, we may be experiencing just another false start in inflation, primarily underpinned by transitory factors such as the oil price recovery and choked off by tighter policy in the US and potentially China.
Economic growth already appears more fragile. In the US, consumer spending has kept the economy out of recession but fell sharply in the third quarter. Questionable labour market dynamics may not support an immediate rebound and productivity remains moribund.
More defensive equity investments, partly represented by CF Lindsell Train UK Equity in our portfolio, would be likely to outperform in this scenario - bonds and gold would also be likely to rally.
Mark Harris is head of multi-asset at City Financial. The views expressed above are his own and should not be taken as investment advice.