Insights from our Chief Investment Office, Dr Raphael Arndt

Across the financial year, global economic growth was stronger than expected and markets strengthened. However, long-term risks are building. The investment environment was generally positive for financial markets over the last year leading to strong returns, although it was a tale of two halves.

The global economy began the financial year showing strong momentum and synchronised growth across most major markets. Low inflation, accommodative monetary policies and low bond yields supported equity markets and delivered exceptionally strong returns to investors with very little volatility. On top of this, the prospect of tax reform and fiscal stimulus in the United States provided a further boost.

As 2018 unfolded conditions became somewhat less favourable leading to a marked pick-up in market volatility with significant falls in asset prices. An acceleration in wages in the US in February led to concerns of increasing inflation. Tighter monetary policy fed into higher bond yields and falling equity prices. Around the same time, global economic momentum peaked and showed more divergence, with European growth moderating sharply while the US continued to show strength following its fiscal package.

As the year progressed trade concerns moved to centre stage, with the US imposing tariffs across a range of industries and countries and several of the impacted countries retaliating. This led to heavy selling of risk assets in the December quarter. In the new year central banks became generally more accommodative, including signalling a tolerance for an inflation overshoot. This, together with some accommodation in the trade dispute, led markets to rally.

While economic conditions appear to have peaked for this cycle, monetary policy remains broadly supportive of growth in developed markets. Fiscal policy in the US is expected to support economic growth throughout 2019.

Beyond the next year the economic outlook becomes significantly less certain. The gradual erosion of spare capacity in developed markets may lead to inflationary pressures, particularly in the US. Setting monetary policy to ensure that the expansion is maintained while capping inflationary pressures will likely prove challenging for central banks, especially if regional differences persist.

This economic backdrop could prove challenging for financial markets and overall portfolio returns in the year ahead. Asset prices generally remain elevated despite the volatility seen in the second half of the year, and markets do not appear to be pricing in the significant risks which lie ahead.

The longer the current expansion continues, the greater the risk of imbalances or inflationary pressures that central banks will look to contain, potentially leading to a
classic recession.

While this risk appears far from imminent, the forward-looking nature of financial markets means that asset values are likely to turn before any economic downturn.
Also complicating the outlook is the fact that expected long-term real returns are low relative to history and become even less attractive when adjusted for cyclical and structural economic risks.

These conditions suggest a moderate exposure to risk assets is warranted. Given the uncertain path ahead, it is important to maintain portfolio flexibility to allow the level of portfolio risk to be adjusted as the increasingly uncertain outlook changes.