Global financial markets at present are caught between two possible scenarios for the year ahead: the so-called risk-on “Trump reflation” trades, and the risk-off “geopolitical” risk concerns. Each scenario favours a different set of investment ideas. But this does leave the question: which type of investment might do reasonably well under either scenario?
As I’ll explain, I think that might be the Australian banks.
For starters, Trump reflation focuses on the prospect of continued strong US economic growth, underpinning by fiscal stimulus. In turn, it’s a world in which the US dollar and bond yields rise, equities generally do well and gold slumps. Within equity markets, the Trump reflation scenario favours sectors likely to most benefit from a rising US dollar and/or higher bond yields – such as global banks ETF (BNKS) or currency-hedged Japanese equity ETF (HJPN).
Why? Global banks find it easier to fatten net-interest margins in a higher bond yield environment, especially as yield curve steeps. Japanese equities, meanwhile, most benefit when the Yen is weak, due to the support this gives Japan’s mighty exporters.
But in a risk-off world, recent jitters in global markets suggest that it will be gold, the Yen and government bonds – rather than the US dollar – that act as favoured safe havens. Should European elections usher in anti-EU hard right populist parties and/or US President Trump blunders his way into a major trade or military misadventure, the Yen will skyrocket (hurting Japanese stocks), while gold will also spike higher. And so-called equity “bond proxies” like listed property and infrastructure should also perform well – at least in a relative sense – given the likely decline in bond yields.
So what scenario is most likely? To my mind, the threat of hard right electoral victories in Europe is diminishing (even though polls are not as reliable as they once were). And as for geo-political risk, the only real wild card is North Korea – how the US will try to deal with this clear threat, and how the rouge state then reacts. This is clearly a risk factor which can’t be ignored, but we can at least have (some) confidence that Trump will be advised not to be so reckless as to risk a North Korean strike on South Korea. Most likely will be hard diplomacy that tries to appease North Korea through improved trade arrangements. Another (possible?) option is American efforts to essentially shut the country down through cyber tactics, which might provide enough time for regime change through internal or external military force.
All up, barring shocks from North Korea, the most likely scenario is that any “geopolitical” shocks will be sporadic and fleeting – if anything, they will provide buying opportunities for the stronger and likely more enduring Trump reflation theme over the next year or so.
That said, it begs the question: if you wanted to hedge your bets to a degree, which investment theme might fare reasonably well under either scenario? To my mind, that would be Australian financials, such as through individual bank names or a local financial sector ETF (such as QFN). After all, banks should perform OK in a risk-on world, as rising bond yields will help global financials in general. Despite being a high-yield investment, local banks won’t be hurt as much as bond proxies.
But in a risk-off world, while local financials might not perform as well as purer bond proxies like listed property, the still relatively attractive yields offered by banks might still garner investor interest – if only because there would be a lot of money fleeing the resources sector, which has attracted a lot over investor interest over the past year.
So if you are unsure which way the wind will blow this year, some exposure to the local financial sector seems to make sense – given that its offers attractive income in a defensive world, but also some risk-on upside potential if we avoid geopolitical disasters.
