Nowhere was this more apparent than in Europe, whose cyclical economic recovery accelerated and broadened across the region’s underlying countries. Meanwhile, the threat of deflation diminished on the Continent, allowing the European Central Bank to begin reducing its monthly asset purchases.
Following the Brexit vote and Donald Trump’s election in 2016, investors had been particularly concerned about European political risk at the start of the year. However, a number of risk events ended with market-pleasing results, including Mark Rutte’s victory over Geert Wilders in the Dutch election in March and Emmanuel Macron’s defeat of Marine Le Pen in France’s presidential election in May.
These developments allayed investors’ concerns over the threat that populist political movements pose to the eurozone’s ongoing viability. In turn, improved sentiment supported both the euro and European equities.
Following the Brexit vote and Donald Trump’s election in 2016, investors had been particularly concerned about European political risk at the start of the yearPolitical events were also influential elsewhere in the world. In the UK, Brexit uncertainty persisted and political risk increased further as the Conservative Party surprisingly lost its parliamentary majority. Despite these events, the economy performed better than expected, allowing the Bank of England to reverse the emergency interest rate cut it had implemented following the Brexit referendum.
This helped sterling exchange rates stabilise, albeit well below their pre-referendum levels, which weighed on the relative performance of UK equities. Conversely, Japanese political risk declined as Shinzō Abe was re-elected as Japan’s prime minister, despite various political scandals threatening to undermine his position earlier in the year. Together with encouraging signs from the Japanese economy, this helped Japanese equities outperform their developed world peers.
In the US, Donald Trump continued to dominate headlines, but his administration’s attempts to implement the reforms he had promised disappointed for most of the year. In particular, its failure to repeal and replace the Affordable Care Act indicated a lack of consensus and infighting within the Republican Party. Nevertheless, expectations of fiscal stimulus boosted economic sentiment, helping the US economy strengthen further over the course of the year, and it now appears that some meaningful progress is being made in terms of reforming the US tax code.
Although the US economy continued to grow at a robust rate, inflation was held back by various structural headwinds. This ensured that the Federal Reserve kept its monetary policy accommodative, despite it raising interest rates and beginning to reduce the size of its balance sheet. While the European and Japanese economies also strengthened, inflationary pressures in both remain subdued. Even in the UK, where inflation has risen above the Bank of England’s target rate, this was largely due to sterling’s devaluation.
With tighter US monetary policy having already been priced into markets at the start of 2017, the dollar weakened throughout the year as other regions’ economies improved at a faster rate. This provided support to commodity prices and the emerging markets, whose equities made strong gains, outperforming their developed world peers. The resilience of China’s economy also helped, but we are cognisant that this was largely the result of fiscal stimulus and the government’s decision to allow credit growth to outpace broader economic growth, which supported the property markets of its second and third-tier cities. We see each of these trends as unsustainable over the longer term.
Overall, 2017 was positive for risk assets as improving growth, low inflation, accommodative policy and political developments combined to create a ‘goldilocks’ environment which helped many equity markets surge to new all-time highs. However, markets remain vulnerable to both a faster-than-expected rise in inflation and a growth slowdown. As such, we believe a balanced approach to portfolio construction is warranted.
With equity market valuations above their historical averages in some areas, we also believe sectoral and geographical asset allocation decisions will continue to be key components of returns over the coming year. With fixed-income valuations also high by historical terms, we see value in utilising non-equity asset classes such as structured notes, convertible bonds and hedge funds to diversify investment portfolios.
Edward Park is director of the investment committee of Brooks Macdonald
