Investors should keep an eye on inflation

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Investors should pay attention in 2018 to, among other things, rising inflation as well as U.S. tax reform and the outcome of the NAFTA negotiations, say GAM experts in the latest market outlook.

According to GAM's investment experts, 2018 will be marked by various market developments that will determine investor behavior. Investors should keep an eye out for potentially rising inflation in 2018, as Larry Hatheway, group head investment solutions and chief economist, advises. This is particularly important, she says, because the markets are virtually unprepared for this scenario, even though the overall economic situation points in that direction. Further, political decisions regarding U.S. tax reform and NAFTA negotiations are also likely to affect the market and economic growth of certain countries.

Central bank policy determines future market direction
Divergences between economic growth and central bank policy are likely to create opportunities for fixed-income investments in global markets in 2018. The current market environment is characterized by rising interest rates and government bond yields as well as tight spreads. Tim Haywood, investment director for fixed income absolute return strategies, says investors are likely to be more concerned about the types of credit risk they take and focus on company-specific fundamentals going forward.

"Strong demand for corporate bonds has led to good performance and a narrowing of spreads across good and lower quality issuers. In our view, this will change in the future. Although we believe this segment of the bond market still holds potential for investors, there is now a need to blend traditional research based on financials with more modern investment techniques such as long-short and relative value trades", says Haywood.

European equities return to "normal Volatility back
Over the past twelve months, overall volatility in bond markets has been very low. Investors were hardly impressed by global events that would have triggered short-term fluctuations or rotation in equity markets in the past. "The continued expansion of the ECB balance sheet undoubtedly had a calming effect, but also led to inflated valuations in certain areas of the market that were seen as 'safe havens'", says Niall Gallagher, portfolio manager for European equities at GAM.

Fund investors have also jumped on this trend, as evidenced by the positive net inflows into "low-vol" funds- or "short-vol"-Investment products. "It is impossible to say with certainty what will trigger a return to normalized volatility levels. But the impending reduction in the Federal Reserve's balance sheet is likely to be a test of strength, particularly for bond-like equities", says Gallagher.

Consequences of US tax reform for mergers and acquisitions
U.S. tax reform could be an important event to watch in 2018 for the mergers and acquisitions (M&A) market and the stock market in general. Roberto Bottoli, Portfolio Manager for Merger Arbitrage Strategies, believes: "When the reform takes effect, we could see increased merger and acquisition activity, supported by additional resources from tax savings and potential capital repatriation."

But the reform proposal would also place limits on the deductibility of interest expense. This would limit the use of debt and ensure that certain leveraged buyouts, typical of private equity firms, would become uneconomical. This would limit these types of transactions.

Implications of the NAFTA negotiations
In early 2018, we should learn more about progress on NAFTA negotiations, giving us a better sense of the direction of U.S. policy with respect to global trade. Paul McNamara, Investment Director for Emerging Markets Bonds, believes the outcome of these negotiations could have far-reaching implications for emerging markets in general and Mexico in particular: "President Trump's protectionist stance remains a huge risk to economic growth in emerging markets. A shift to higher tariffs would have significant implications for all emerging market currencies. In addition, elections in Mexico, the reform process and elections in Brazil, party politics in South Africa and developments in Turkey could also lead to higher volatility in emerging market returns."

Cat bonds: After the hurricane is before the hurricane
John Seo, investment director for insurance-linked securities and managing director at Fermat Capital Management, expects a 10 percent increase in risk-adjusted returns for catastrophe bonds and adjacent areas of the insurance-linked securities (ILS) sector in 2018. In 2017, active returns offset losses, so the bottom line total return was positive despite a series of loss events, led by Hurricanes Harvey, Irma and Maria (HIM). For the ILS market, some fundamental realities are not yet clear: HIM losses are expected to be 'only' $60 billion, not $100 billion as initially assumed", explains Seo. The GAM expert also expects catastrophe bond issuance to break all records in 2018, with $12 billion worth of paper likely to be brought to market.