If ever investors wanted proof that uncertainty and political events in markets is a fuse to volatility but that economic fundamentals win, 2016/17 would be a good case study. Despite fears of an uncertain geo-political world results were strong in all equity markets – the area volatility excels.
Financial markets commenced 2016/17 in the wake of the Brexit result just a few days before and offered a frightening outlook. At the same time we had looming elections in Europe, where extremist candidates seemed to be making headway, as well as an unheralded US Presidential election with Clinton vs Trump. As things turned out, the European elections proved more benign than feared, the US election delivered one of the most startling results in decades and markets responded favourably through economic policy stimulus. Who would have imagined that?
After all the turmoil, global equity markets commenced a sustained rally that delivered strong double digit gains for the year as a whole. Other risk (equity) assets, such as high yield bonds, also performed very well. However, government bond markets had a poor year and bond-sensitive equities, such as AREIT’s [Australian Listed Property], underperformed with negative returns. In general these developments were driven by investors chasing the “reflation trade” – that is, a view that the world economy was finally entering a period of better growth with moderate inflation.
As 2017/18 starts, risk assets are looking less attractive than a year ago and markets are facing up to the end of the global interest rate easing cycle. From here on, interest rates go up rather than down, with implications for all asset classes, but most especially bonds and currencies. At the same time, the pace of global growth looks set to slow down, thereby providing less support for profits and cash flows. Given all this, equity markets sitting on high valuations look vulnerable to many analysts.