After a testing start to the year, risk assets rebounded in the second quarter with the US equity market making new highs. Underpinning this were signs of better economic activity in the US and continuing recovery in Europe, whilst China began to show signs of stability. The sense that central banks were becoming less supportive of economic activity dissipated and then reversed as the European Central Bank (ECB) announced a range of measures to support growth and head off deflation. Meanwhile, Federal Reserve (Fed) chair, Janet Yellen emphasised that US interest rates would remain low well into the future, even as the economy recovered.
The environment remains positive for markets in the second half of the year. However, as valuations push higher we are examining our stance on risk assets. Equities continue to look attractive, but we see scope for some profit taking and a rotation towards those markets which have lagged the rally.
Against this backdrop the decision to focus our risk budget on equity markets has proven correct, but we have also seen strength in credit, emerging market debt and peripheral European sovereign bonds. Carry trades are coming back and there has been a rally in the fragile 5 currencies. Encouraged by central bank commitment to easy policy and the low level of volatility, investors have resumed their search for yield.
Going forward we see continued recovery in the world economy and are looking for growth in the developed world to gradually spread to the emerging markets through stronger trade. However, alongside this positive development we also anticipate upward pressure on US rates as the labour market continues to tighten and inflationary pressures build. Corporate profits may than come under pressure as wages pick up. Market reaction will depend on how the Fed responds and we see a strong case for the higher interest rates in the US (see Strategy note). Elsewhere though, monetary policy is expected to remain easy with the ECB and Bank of Japan looking to stimulate growth and head off deflation.
Notwithstanding these challenges, the environment remains positive for markets in the second half of the year. However, as valuations push higher we are examining our stance on risk assets. Equities continue to look attractive, but we see scope for some profit taking and a rotation towards those markets which have lagged the rally.
Keith Wade, Chief Economist and Strategist, Schroders
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