Five-Year Capital Market Outlook - 2017

Issues for investors as the central bank liquidity wave crests

April 26, 2017

Economic policy and political uncertainty caused the big surprises in 2016, eg Brexit and the US election, and are elevated globally. This widens the distribution of possible future outcomes for global growth and inflation – both downside and upside – and is a catalyst for greater divergence between economies. To help investors manage this higher uncertainty and complexity, we have covered a wider range of capital market issues and portfolio strategies than normal. To help navigate our work we provide 10 recommendations across the key decision-making areas that investors need to consider: risk management, portfolio construction, implementation and monitoring.

Executive summary

  • Easy monetary policy – despite Fed rate rises – and fiscal easing are likely to produce moderately above trend global growth and lift developed world inflation in the next two years. Over our five year horizon, monetary tightening will slow real growth.
  • The possibility of outsized positive and negative growth and inflation surprises has risen.
  • Waves created by years of falling interest rates and central bank liquidity – which increased asset prices – have crested. We expect positive but low long-term asset returns, with rising downside risks over time.
  • Investor responses are: (1) understand portfolio exposure to downside and upside risks; (2) phase strategic risk changes over time; (3) diversify and consider tail risk hedging; (4) maintain liquidity and wait for major market over/undershoots; and (5) use active management.
  • Strategic FX hedging policy needs to incorporate additional new regulations which typically increase the costs of FX hedging. Cyclically, currencies will likely have an important impact on portfolios as currency volatility rises.
  • Lower illiquidity premia, slowing deal activity, and all-time high dry powder requires investment selectivity.
  • Lower average correlations across and within asset classes and rising volatility amplifies the gross potential alpha from concentrated best-in class portfolios.
  • While higher return dispersion provides more opportunities for active managers to add value, investors can maximise the net returns they receive through better implementation.

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