Asset Allocation views from the BMO Multi-Asset Investment Team

Faced with negative interest rates on deposits and government bonds, as well as very low yields on credit instruments, investors are pushing further into risk assets. Within equity markets ‘bond proxies’ are trading at elevated levels of valuations as investors chase ‘safe’ earnings and dividends.

The expectation (currently in the market) that the US will not raise interest rates again until 2018 is helping to pull down yields globally and exacerbate these trends.
All is not well, however. Negative yields reflect poor global growth prospects and depressed inflation expectations and quantitative easing (QE) has so far failed to spur consumer demand as much as hoped or encourage corporate investment. Despite a new record high in the S&P 500, earnings are declining in the US at the same time as valuations are rising.

Japan leads the way
Japan again looks to be at the forefront of policy experimentation. ‘Abenomics’ appeared to have a chance of reigniting growth but equity market gains have evaporated as the currency has strengthened. Inflation expectations have slipped and growth is, once again, poor. Return on equity and margins have risen to historically high levels (in a Japanese sense) but structural reforms will take years to bear fruit. Politicians and investors are impatient on progress. Increasingly, there is speculation that Japan will be the first major developed nation to link fiscal expansion with monetary easing.
Nonetheless, it may be difficult to replicate the positive surprises associated with ‘Abenomics 1.0’ but, given the ‘super-majority’ that Abe now enjoys, there will likely be more by way of radical action. We can expect overt debt monetization to ratchet up a gear in an effort to boost growth.
Such moves mark a turn away from central bank independence but we can expect other regions to follow in due course – at least in terms of fiscal expansion (or easing austerity). Where this leaves government bond markets is unclear but we believe that investors are under-pricing inflation risk.

The continuing search for yield
One reason that equity markets may be being re-rated at the present time is due to the fact that bond yields have fallen so low. The yuan is weakening again, inflation expectations globally are declining, more easing is likely from the European Central Bank, the Bank of Japan and the Bank of England while the Federal Reserve (Fed) is assumed to be on hold indefinitely. This has pushed around a third of benchmark governmentbonds into negative yields and the gap between global government bond yields and equity yields has reached a 60 year high. The ‘Fed model’ stoppedworking a long time ago but it may well be that the downside inequities is limited by their relative yield characteristics for the timebeing while the upside is limited by weak earnings growth.

We seem likely to be stuck in an extended trading range for equitieswith periodic bouts of volatility offering both risk and opportunitiesfor investors.

Multi-Asset Investment Team – BMO (Bank of Montreal)