Global Markets Overview - Asset Research Team March 2018
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Global Markets Overview
Asset Research Team
March 2018
What asset markets are pricing-in and our outlook
1. Monthly overview term in 2022. In March, proposed reforms are
According to the US Federal Reserve meeting expected to be reviewed by the National People’s
minutes from January, FOMC members saw the Congress.
US economy gaining momentum. A majority of
2. Our Five-Year Outlook
participants noted that a “stronger outlook for
economic growth raised the likelihood that further In January, we published our Five-Year Outlook. A
gradual policy firming would be appropriate”. Several summary is provided below:
policymakers indicated that they had “marked up
While cash rates have started to rise, for now,
their forecasts for economic growth in the near term
policy generally remains accommodative…
relative to … the December meeting.” Others noted
that “upside risks” to growth may have increased. … supporting above trend GDP growth and rising
Fed Chair Powell was positive on the outlook inflation over the next 18 months.
before Congress. In his first testimony to the House Further out, monetary tightening should result in
Financial Services Committee this month, Federal slower real growth and rising downside risks.
Reserve chair Jerome Powell highlighted above
trend economic growth and emphasized his We believe that a recession is slightly more likely
confidence in the FOMC achieving its inflation target. than not over five years.
Powell added that “in gauging the appropriate path Relative to our medium-term outlook, we think
for monetary policy over the next few years, the valuations for growth-related assets are high and
FOMC will continue to strike a balance between expect low returns on average.
avoiding an overheated economy and bringing PCE
price inflation to 2 percent on a sustained basis.” 3. What Asset Markets are Pricing-in and
The Bank of England kept rates unchanged but our Outlook
raised expectations for earlier hikes. The Bank’s
This month, we review our market-by-market
Monetary Policy Committee voted unanimously to
outlook.
keep the official Bank Rate unchanged at 0.50%.
Governor Carney highlighted, however, that the MPC Global interest rates
“expect that in order to return inflation sustainably to
Developed markets
target . . . it will probably be necessary to raise
interest rates . . . somewhat earlier and to a Bond yields have moved up notably year-to-date.
somewhat greater extent than we had thought in From current levels, we expect bonds to provide
November”. The bank also upgraded its GDP growth decent returns relative to cash over five years. We
forecast for 2018 to 1.8%. believe that a recession is more likely than not over
this period that will cause policy rates to be cut
Proposals to end the Presidential term limit in
towards zero and bond risk premia to fall. This would
China. The Communist Party Central Committee
push government bond yields below expected levels
have proposed scrapping the two-term of office limit
over the medium term, given markets are pricing-in
for the state president and vice president from the
sustained hikes (Exhibit 1), and support bond returns
constitution. If approved, this would allow President
above current bond yields.
Xi Jinping to serve beyond the end of his second
© 2018 Towers Watson Limited. All rights reserved.
willistowerswatson.comWhat Asset Markets are Pricing-in and our Outlook
Our near-term return outlook remains negative, albeit Exhibit 1: Markets price-in future cash rates in line
less than previously given recent yield rises. Over with our short-term expectations but high longer-term
the next 12 to 18 months, we believe that yields will
probably rise more than is priced-in as investors 6 1y zero coupon rate, %
extrapolate positive cyclical growth conditions into Plausible range
5
their rate expectations.
Global GDP-weighted 1y
4
Local currency emerging markets What's discounted
Average forward rate pricing of emerging market 3
(“EM”) local currency sovereign bonds appears 2
sensible given aggregate cyclical conditions. We
1
expect reasonable returns driven by the starting level
of EM local currency bond yields. In the shorter-term 0
EM currency appreciation should also support
-1
returns, before global economic risks rise. 97 02 07 12 17 22 27
Source: Bloomberg LP, Federal Reserve, Bank of England, IMF, Willis Towers
Credit markets Watson; Notes: the plausible range conveys the upper and lower bounds of rates
paths consistent with our outlook.
Corporate credit markets
Exhibit 2: Implied corporate default rates are low
Spreads have widened very modestly in recent relative to historical levels
weeks. Nevertheless, markets continue to price in a
low level of default/downgrade risk both in absolute Market
Implied default 10-yr average
terms and relative to historic averages. Over a five rate (%pa) (%pa)
year horizon, our outlook for defaults and Investment grade corporate
downgrades remains more pessimistic. US 0.0% 2.3%
Our shorter term outlook allows for continued Euro -0.4% 1.7%
economic and asset price momentum over the next UK 0.7% 2.7%
Canada 0.1% 1.3%
12 to 18 months. Therefore, we cannot rule out High yield corporate
further spread tightening. However, corporate credit US 0.7% 4.7%
upside potential appears constrained by already Pan-Europe 0.5% 5.2%
narrow spread levels.
Hard currency sovereign
Emerging market sovereign credit Emerging 1.4% 3.1%
USD-denominated emerging market sovereign credit Source: Factset, Willis Towers Watson. Notes: calculations assume 30-60%
recovery rate for corporate credit, 50% for sovereign; 100bps credit and illiquidity
pricing implies a default environment modestly below premia for IG markets; a 250-300bps risk premia for HY markets and sovereign.
ten year average levels but notably above developed
economy corporate markets. We expect defaults to Exhibit 3: ~35% – the average cumulative equity
drawdown over the past five US recessions
be modestly lower than the level implied by current
market pricing. On a risk adjusted basis, hard 120 MSCI World index, rebased to 100 at start of recession
currency EM sovereign credit returns appear more
attractive than for corporate high yield. We expect
defaults to be lower and spreads to be less
90
susceptible to a worsening economic environment.
Global equity
GFC
60
Long term sales and earnings growth priced-in by Dot com bust
Early 1980s
equity indices continues to be within a plausible Mid1970s
range relative to our expectations, albeit towards the Early 1990s
months since start of recession
upper-end in a few key markets, most notably US 30
large cap. 0 12 24 36 48 60 72
Source: Bloomberg LP, Willis Towers Watson
Asset Research Team
© 2018 Towers Watson Limited. All rights reserved. Global Markets Overview 2What Asset Markets are Pricing-in and our Outlook
Over a five year horizon, we expect slowing Brexit-related uncertainty in the UK, and fiscal and
demand growth due to rising interest rates to be a monetary policy uncertainty in Japan, mean the
major downside risk to equity returns. We think that bands of uncertainty around our central outlook are
a mild global recession is more likely to occur than unusually wide. In contrast, cyclical risks look more
not, resulting in significant equity drawdowns (see tilted to the downside for AUD and EUR in our view,
Exhibit 3, for instance). We forecast low equity more so after their recent spot appreciation.
returns on average over five years. Emerging market currencies, that have improved
As it is difficult to predict the timing of a downturn, external balances and are moderately undervalued,
investors should start to plan their portfolio strategy face moderately supportive return conditions in the
responses now. shorter term. However, the prospect for global
Over the shorter-term, we note that earnings growth recessionary conditions is a clear downside risk
above market expectations could result in good over five years.
returns, particularly in markets where equities are
pricing-in longer term earnings growth that is Alternative betas
meaningfully below our outlook (e.g., parts of the Our outlook for the major alt. beta strategies are:
Eurozone).
The carry strategy captures the return from
Foreign exchange investing in higher yielding assets relative to those
with lower yields, i.e. a yield spread. Yield spreads
The USD has stabilised over the last month in many carry markets remain low due to
following commentary around monetary policy accommodative monetary policy, leading to
normalisation from the Fed. Market pricing in FX headwinds for the strategy.
forward markets remains for broad USD Merger arbitrage remains relatively attractive as
depreciation over the medium term – reflecting deal activity is still healthy and failure rates are low.
expectations for higher interest rates in the US A continued steady expansion of the business cycle
compared with other developed economies. in the next 12 to 24 months may continue to support
Our central outlook for a maturing business cycle, M&A activity providing support to the strategy.
tightening global liquidity and recessionary risk Reinsurance premiums have fallen in recent years
increases the chances of FX volatility in the near due to low claims and the accumulation of capital in
and medium term. We think the risks are broadly the industry. Following a year of high insurance
reflected in current GBP and JPY pricing. However, losses owing to storms and wildfires in the US,
Exhibit 4: EUR appreciated vs. the USD despite Exhibit 5: Headlines of key alternative beta views
rate differential widening. We think cyclical risks
are now more downwards skewed Strategy Current View
1.25 -1.0 Carry Low yield spreads across markets offer
-1.2 headwinds
1.20
-1.4 EM Currencies Hold at or modestly above a strategic
1.15 allocation
-1.6
1.10 -1.8 Merger Remains healthy, but we are monitoring
arbitrage developments as the business cycle matures
1.05 -2.0
-2.2 Reinsurance Modest uptick in premiums following large
1.00 EURUSD (LHS)
-2.4 insured losses in 2017
0.95 EUR 2 year yield minus US 2 year yield Volatility Faces headwinds from a very low and
-2.6
(%, RHS) premium choppy volatility environment. Monitor recent
0.90 -2.8 rises in volatility
Jan-16 Jul-16 Jan-17 Jul-17 Jan-18
Source: Bloomberg LP, Willis Towers Watson Source: Willis Towers Watson
Asset Research Team
© 2018 Towers Watson Limited. All rights reserved. Global Markets Overview 3What Asset Markets are Pricing-in and our Outlook earthquakes in Mexico and floods in parts of Asia and Europe, premiums have improved by about 10- 20% during January renewals. This constitutes a slight improvement in the context of the declines in premiums in recent years. The volatility premium strategy, which captures the difference between the implied volatility of an asset and its subsequent realised volatility, faces headwinds in an environment where volatility is rising or is low and choppy. Whilst performance has been steady over the last couple of years on account of falling volatility, the strategy faces headwinds as a reflationary regime could cause volatility to rise or create quickly resetting spikes as we have seen over the last month. It remains to be seen whether the recent rise volatility will be sustained and therefore offer more attractive pricing for the future. Asset Research Team © 2018 Towers Watson Limited. All rights reserved. Global Markets Overview 4
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