GAM Investment Solutions - Markets in February 2018

Investors clearly shifted their sights at the beginning of February this year, and that is probably a precursor to market performance for the remainder of 2018. Volatility has returned to markets for several reasons. For one, markets were priced to perfection by the end of January, following a strong run throughout 2017 and at the beginning of this year. Inevitably, disappointments were going to be more likely. They arrived first in the form of unexpected US inflation, which raised doubts about the Federal Reserve’s monetary policy response.

Next in line are the US tariffs imposed, initially for solar panels and washing machines, then steel and aluminium, and most recently against China for intellectual property right infringement. Fears of trade conflict have increased global tensions, exacerbating market volatility. Whether the source is inflation or trade policy, these are unlikely to be the final salvos of 2018.

Take trade. President Trump campaigned for election on a platform of preserving US manufacturing, as well as coal production. It is hardly surprising that he has finally reached into the protectionist toolbox. If anything, the surprise is that it took him this long.

Protectionism is a dangerous issue for the capital markets because it threatens global growth, particularly if it is reciprocated by retaliation elsewhere. Thankfully, the responses from Europe, China and others have been restrained and, in consequence, the US has scaled back the impact of its tariff measures. However as we head into the US mid-term elections in November and then ramp up the importance of domestic politics into the 2020 elections, it would be prudent to assume that President Trump will again resort to policies that appeal to his base, among them protectionism. This appears to be a recurring source of market concern.

The same is true of inflation. As economics approach full employment in North America, the UK, Northern Europe and Japan, price and wage pressures are likely to intensify. To be sure, this is largely a welcome development, as economies return to normal rates of inflation consistent with ‘price stability’. But there is a growing risk of an overshoot, particularly given added US fiscal stimulus, a weaker dollar and higher oil prices.

The implication is that markets will probably oscillate between viewing inflation as a benign outcome and viewing it as an overshooting risk. In the latter case central banks will have to move more quickly and less predictably to prevent genuine overheating. In doing so, they would naturally increase the risk of a slowdown, perhaps even a recession by 2019 or 2020.

So inflation bears watching. That is because inflation risk is very difficult to address in investment portfolios. Fixed income assets lose value as inflation and bond yields rise, but so too do equity risk premiums. Indeed, apart from a few ‘safe haven’ assets, it is difficult to find asset classes that are not negatively impacted by an inflation overshoot.

Accordingly, 2018 is likely to be a story of recurring volatility and lower overall returns. Investors will have to focus increasingly on capital preservation and on forms of portfolio construction which tend to minimise drawdown risk. The markets have changed. So, too, must investment strategy.

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