InvestmentsJun 15 2016

What multi-asset investors can expect from markets

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What multi-asset investors can expect from markets

The Bank of Japan surprised investors at the end of January by pushing interest rates into negative territory.

In the normal course of events, that would have been viewed as positive for growth and optimism and a negative for the yen. But markets decided on a more negative interpretation.

The yen strengthened unexpectedly, from around 120 against the US dollar to around 112 by the middle of February.

That hurt the Japanese stock market, which is driven by large export industries. Equities also fell around the globe.

Banks were hard hit as investors focused on the implications for their margins. Sentiment was affected more broadly by the sense that central banks were running out of policy options.

It is clear the actions of major central banks remain one of the factors multi-asset investors need to take into account

However, sentiment towards risk assets began to improve in mid-February as the focus switched to the European Central Bank’s (ECB) policy meeting in March.

Comments by the Bank’s president, Mario Draghi, raised expectations that a significant announcement would be made.

These expectations were correct: the ECB announced a reduction in key interest rates, an increase in asset purchases of €20bn per month, a six-month extension to the period over which asset purchases would be made, the inclusion of non-bank corporate bonds in the asset purchase scheme, and new targeted long-term refinancing operations with very attractive terms for banks.

This package of measures helped shift the market’s focus away from the implications of negative rates towards measures that might encourage the creation of credit in the real economy.

But, once again, the exchange rate response was unexpected.

The euro strengthened, rather than weakened, in part because Mr Draghi suggested further rate cuts in the future were unlikely.@Image-df29bef8-27af-4079-ae63-bc1018ffe0bb@

The euro and the yen were given a further boost towards the end of March, when the Federal Open Market Committee released a doveish statement and lowered its forecast for future US rates.

In April, attention shifted back to Japan. With the numbers out of Japan continuing to disappoint, financial markets assumed further policy measures aimed at stimulating growth would be announced at the Bank of Japan’s policy meeting towards the end of the month.

Indeed, as the meeting approached, rumours of a targeted long-term financing operation, similar to that implemented by the ECB, built – so it was a surprise when no new policy measures were announced.

It is clear that the actions of major central banks, and expectations surrounding them, remain one of the most significant factors that multi-asset investors need to take into account.

The impact on currency markets has driven performance across asset classes. The stronger euro has meant key European equity markets have underperformed. The weaker US dollar, particularly after the ECB and Federal Open Market Committee meetings, helped commodities to recover from sharp losses and improved sentiment toward emerging markets.

The question now is what the major central banks will do next.

At the time of writing before the Bank of Japan’s June meeting, it appears the economy is in clear need of a further boost, and this has become all the more pressing as the yen has strengthened. The Japanese administration simply has too much invested in attempts to boost growth and inflation to give up now.

By contrast, in the US, given an unexpected domestic slowdown and a recent improvement in China, it seems most of the risks to the Federal Open Market Committee’s forecasts are on the downside – even if it feels unable to say so, having only recently started to hike rates. Until this changes, it is unlikely to hike rates.

While central bank policy is a key driver for markets, it is not the only factor.

Over the last few months, activity data from the US have been disappointing, as have global purchasing managers’ indices. Although recent developments have made us more cautious, we still think 2016 will be a year of moderate growth in the key developed markets. Conditions in China should continue to improve and that should have a knock-on impact on domestic economic conditions in the key economies around the world.

Against this backdrop, we believe emerging markets should continue to benefit from the lower-for-longer rate outlook in the US, and the impact that has had on both the US dollar and commodity prices. A stronger China should also play a part.

At some point, we believe the Japanese authorities will have to announce further policy supports. With the reaction to negative interest rates so adverse, measures that are not related to rates seem most likely. We expect measures to be announced at the next Bank of Japan policy meeting in June, if not before.

We believe that major currency crosses should continue to trade within ranges now that markets have adjusted to a new US rate outlook, but downside risks – linked to potential policy changes – exist for the Japanese yen.

Steve Waddington is multi-asset portfolio manager of Insight Investment

Key points

The Bank of Japan surprised investors at the end of January by pushing interest rates into negative territory.

The euro and the yen were given a further boost towards the end of March.

At some point the Japanese authorities will have to announce further policy supports.