The US Federal Reserve has begun its first new policy-tightening cycle since 2004. At a time of near zero inflation, many observers are wondering why. Others have struggled to understand why the Fed would wait so long as the US labour market has been recovering for five years already.
Despite a slow pace of economic recovery, the US labour market is showing all of the tightening that is typical of any previous rapid recovery. This suggests more "cyclical risk" for financial markets than many might assume.
The argument for the Fed to move away from emergency stimulus is not a call to "prevent happiness", to paraphrase a famous quote on puritanism. It is aimed at weighing against the building imbalance of stimulus when the US economy is growing faster than its potential to grow in the longer term.
While there are few immediate impediments to growth, the steps should be aimed at mitigating risks of a hard landing two years forward. History, however, shows the Fed can rarely do more than mitigate such risks. The Fed's latest projections show both a steady unemployment rate and similar GDP growth during the next three years. This seems quite unlikely, given present trends.
Meanwhile, given the substantial slowing of its economy and the international turmoil its currency devaluation triggered in August, there's a school of thought that the next global recession will be "made in China". But it's hard to put China's slowing growth into a traditional "cycle" framework. Instead, we see it as a change in the drivers of economic growth - towards consumption from exports and investment. This has significant impact on China's trading partners, especially commodity exporters.
Among those exporters, many emerging markets (EMs) have seen currencies weaken sharply and asset prices fall. While there may be some recovery next year, we fear that underlying weakness in many EMs may outlast economic strength in developed economies.
For all the reasons above, and while we still expect the world economy to grow in the coming year, we recommend a strategy that mitigates portfolio risk during 2016, even if risk assets perform well for much of the coming year.
The US business cycle is a key risk for all global investors, given high financial asset price correlation across the world.
As the Fed looks to mitigate risks to the economy two years ahead, so do we in portfolios at the Citi Private Bank. Given that asset prices move faster than the real economy turns, we have gradually been reducing our overweighting in even favoured risk assets well in advance of a business cycle risk which we see becoming more acute in 2017.
This has entailed halving our global equity overweight during the past year and moving higher in largely US dollar-denominated, high-quality fixed income.
Building portfolios that can endure cycles is a key investment theme for 2016. Within this theme, we seek to identify global equity opportunities that are driven by particular longer-term growth trends that are uncorrelated to swings in the business cycle. The rise of healthcare spending in emerging markets is one example.
WE STAY OVERWEIGHT
While euro zone and Japanese GDP data has disappointed recently and policy-easing steps have fallen short of expectations, corporate earnings results are now tangibly exceeding that in the US in these two regions. Over the past four quarters, euro zone earnings per share (EPS) has risen 15 per cent, Japan 19 per cent and the US 2.5 per cent. What the euro zone and Japan EPS data shows is that the case for allocating to the regions goes beyond the mere promise of future quantitative easing (QE) impact.
While not a free-lunch exercise, we continue to prefer equity investments in the two regions on a currency-hedged or partially currency-hedged basis. Even after substantial currency declines this year, and the risk of significant counter-trend rallies, we would expect the persistence of QE and consequent currency weakness for a much longer period than the European Central Bank, for one, formally declares. Japan, with its internally funded low interest rates, negative equity correlation to currency and potential for industrial recovery, seems to be one of the strongest relative beneficiaries of Fed policy tightening.
HIGH-QUALITY FIXED INCOME
A portion of our rationale for cutting our equity overweight in the past year is merely the improving return opportunity in fixed income that higher yields and lower bond prices have presented. Absolute yield levels are still not particularly attractive, though a very low or negative correlation with equities and credit will help dampen portfolio volatility.
Even with the Fed promising a "gradual" pace of tightening ahead, US Treasury yields are well above other high-quality sovereign bond yields. In fact, US five-year note Treasury yields are higher now than the average developed market 10-year sovereign bond yields. In US dollars, investors also now have the potential to earn some positive return on so-called cash equivalents, as Treasury bill returns have moved into clear positive territory.
With the Fed deciding to tighten with inflation still very low and broader global growth moderate, longer-term US rates should be contained.
CREDIT AND COMMODITIES
While we see selective opportunities in credit, the period of both low interest rates and improving private credit quality will not last forever. In the coming year, we continue to expect distress to build for higher-cost petroleum producers. At even US$50 for Brent crude oil - well above the current price - about half of the world's oil producers would be unprofitable in the long run. In 2016, we believe credit stress will be largely limited to energy and commodity producers. Looking further ahead, broader credit issues will, at some point, build up.
For petroleum exporters , whatever recovery oil may have achieved by the time the US expansion hits its peak may be followed by a new plunge. This could help push petroleum-sensitive emerging market assets to reach their secular low before a lasting recovery.
Despite the continuing risks to EM assets as a whole, we are more positive on the immediate outlook for certain regions and countries. We see emerging Asia as a multi-faceted, long-term development story, and also the marginal beneficiary of falling energy costs. We therefore remain overweight on select Asian equities, while underweighting most other EM regions.
•The writer is the global chief investment strategist of Citi Private Bank.