Interest rates must rise at some point in the United States and the United Kingdom. But with ongoing uncertainty about the timing, investors should continue to make sure their portfolios are ready.
So far this year, financial markets have performed in line with our expectations. Most assets have risen in single digits, including equities across the US, Europe and emerging markets; fixed-rate and inflation-linked government bonds; and investment grade and high-yield corporate bonds. US 10-year Treasury yields remain substantially higher than those in the euro zone and Japan, limiting their upside potential. The US Federal Reserve has lowered its long-term US economic growth forecast to a range between 2 and 2.3 per cent, which could cap average long-term rates.
Market volatility may increase as the pace of economic growth rises and quantitative easing (QE) ends. We expect the Fed to complete tapering before year end and begin hiking rates in the second half of next year. As a result, we have revised our forecast for 10-year Treasuries to 2.9 per cent by the end of the year. The market prices in a low-for-long environment in the US. At the start of the year, US 10-year rates had been priced to rise to almost 5 per cent over the next five years. US 10-year rates are now priced to rise to 3.6 per cent in five years.
We are also noting global inflation expectations are low as it remains below target levels across developed economies and many emerging market countries. In Europe, the five-year five-year inflation (the market projections for the inflations levels five years ahead, measured as they would be five years from now) which is one of the indicators the ECB watches on a monthly basis, is below 1.8 per cent, the lowest in 10 years. The real five-year five-year yields in the US are firmly pointing towards 1 per cent. These numbers provide a cautionary perspective on the better growth in the US. As inflation and inflation pressures remain low, there are therefore risks in tightening too quickly and we think the Fed will take a slow approach to it if the current growth is sustained.
While the euro remained strong, euro zone short-term rates rose sharply as banks accelerated repayments of their loans from the ECB’s long-term refinancing operation (LTRO). Following the ECB’s recent stimulus measures, both short-term rates and the euro have been falling against their US equivalents. We believe this trend will continue and have revised our euro/dollar forecast to $1.25 for the next 12 months.
The euro may continue to weaken. This pattern is in line with the most recent ECB actions. The ECB president Mario Draghi has stated his aim is to add liquidity to the financial system to revive lending to the real economy. To this purpose, a weakening currency will benefit the domestic euro economies.
In our portfolios, we are continuing the move we began last year out of extended credit and reducing our overweight gradually. Overall in our portfolios, we remain positive on equities. The drop in bond yields (globally) more than made up for the rise in price earnings ratios in how equity markets are discounting future earnings growth. Given the tight pricing of low growth in equity markets, we still believe that rate normalisation will be gradual. The market complacency will create greater volatility pockets which we will use as an opportunity to rebalance our portfolios. For example, the mid-October global market volatility was one of these events.
In conclusion, as bond yields will gradually pick up and growth slowly improves, investors need to be selective and equities continue to be the place to be.
Cesar Perez is the chief investment strategist for EMEA at JP Morgan Private Bank
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