Q4 2016

Equity rally in Q3

The third quarter saw a reversal of fortune with equity markets rallying whilst government bonds and commodities gave up some of their gains from earlier in the year. Sentiment improved on the back of a firmer macro backdrop and increased liquidity from central banks. High yield bonds continued to perform well, whilst foreign exchange markets were more stable after the volatility of the first half of the year.

As we head into the final quarter of 2016, we are upgrading emerging market equities and downgrading government bonds. There is an element of reflation in both these trades, picking up the modest firming in economic activity which we expect will persist in coming months. We also believe that government bonds are almost priced for perfection and vulnerable to a shift in policy expectations.

Monetary policy under scrutiny

For example, we expect the US Federal Reserve to hike in December and for the ongoing debate about the efficacy of monetary policy to intensify, factors which could challenge markets. We outline our wider asset allocation views (page 2) whilst the research note examines the broken transmission mechanism to the real economy and asks whether we have reached the end of the line for monetary policy (page 22).

Looking further out, the low level of bond yields makes the medium term prospects for government bonds look poor and we expect negative real returns over the next seven years. Equities fare better and continue to offer a risk premium, although it is a mixed picture across the different regions (page 14).

Outlook could change after US election

Of course, the outlook could be radically changed should we get a surprise in the US Presidential election on 8th November. Fiscal expansion and trade protection are on the agenda. Many fear that the factors which drove the Brexit vote in the UK are present in the US and we take a look at both candidates' economic polices and prospects (see page 12).