World in transition spawns multiple risks

This article is part of
Multi-Asset Investing - December 2015

As liquidity-addicted financial markets remain vulnerable to break outs of volatility and multiple sources of risk shape a complex geopolitical environment, it is crucial to base investment decisions on strong macro fundamentals.

Across the globe, multiple transitions are happening at different levels. A gradual pick-up in gross domestic product growth is generally expected in 2016, supported by healthier domestic demand in both Europe and the US.

The underlying drivers of this acceleration are governments’ continued loose monetary policies, improved confidence and labour market conditions, and a gradual return to neutral fiscal conditions in the euro area. Also contributing to internal demand in developed markets is the wealth effect derived from low oil prices.

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Asynchronous central bank policies are one consequence of these transitions.

The European Central Bank has introduced a possible expansion of quantitative easing (QE), China has cut interest rates and its reserve requirement ratio in an effort to strengthen its economy. Elsewhere, the Bank of Japan has decided to continue the current pace of its QE and the US Federal Reserve appears ready to hike interest rates.

China is also dealing with a challenging transition, trying to overcome its past growth model that relied on exports, investments and commodities. This poses some threats to those emerging markets still too dependent on these factors.

At this stage, the diversified picture across China’s sectors suggests the deep structural transition is underway, with a painful cut in overcapacity. Success, however, will mostly depend on the actions of Chinese authorities, which are putting in place a number of measures to avoid a hard landing and are now committed to reforming the real parts of the economy.

Huge secular transitions are also affecting the world population. The flows of refugees crossing European borders are an outcome of multiple geopolitical tensions and a worsening situation in the Middle East and North Africa – challenges that will again test Europe’s political capacity to develop a coordinated response.

Our risk map is therefore crowded and the impact of such risks on financial markets may be significant. This is especially so in an environment where high liquidity has altered in some way the natural market-price equilibrium, leaving room for spells of volatility.

The macro environment is still positive for equities (mainly in the European Union, Japan and selective emerging markets) but the long list of risks means investors should remain vigilant of any dangers. However, relative value strategies at the sector or security level can help generate value during a phase where returns for most asset classes are expected to remain low for a long time.

Matteo Germano is global head of multi-asset investments at Pioneer Investments