Given how well investors have been doing lately, many are probably hoping for more of the same in the coming year. But what they should really be wishing for is that economic and policy fundamentals improve to the point that they validate existing asset prices, while laying a foundation for greater gains.
NEWPORT BEACH – If financial investors were to write letters to Santa Claus this Christmas, they would probably be tempted to ask for the continuation of the unusual combination of factors that has dominated over the last year: ultra-low market volatility, booming financial-asset values, correlations that lower the cost of portfolio risk mitigation, and promising new opportunities (such as Bitcoin). But before making their wish list, investors should consider the longer-term risks associated with the decoupling of financial markets from economic and policy fundamentals.
Investors could be forgiven for hoping for more of the same. After all, with less than a month to go, 2017 is on course to be a hugely, if not historically rewarding year for them. As of December 12, global stock markets, and in particular the S&P index, had returned around 20% for the year – and this on top of an already-strong multi-year run. Add to that unusually low volatility – in the US, 2017 so far has shown the lowest daily loss in the entire history of the S&P 500 index – and there has been little to keep investors up at night.
Usually, such strong stock returns are accompanied by lower prices for government bonds – the so-called negative correlation between risky and safe assets. Not so in 2017. Despite the impressive equity rally, the price of longer-term US Treasury bills was higher at the beginning of December than at the start of the year.
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