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October 2017

As we head towards the end of the year, Polygon’s portfolios are up 10-15% year to date—depending on the client’s risk aversion—despite a conservative orientation. Our current asset allocation model is approximately 65% equities, of which half is in the U.S.; the remainder (35%) is roughly 50% short-term bonds and 50% alternatives. We believe that continued caution is warranted, given high stock market valuations (particularly in the U.S.), coupled with heightened geopolitical risk.

Having recently spent several days in Washington I thought it might be of interest to report on a flurry of meetings which we participated in. These included the annual International Monetary Fund gatherings, as well as a series of roundtable discussions sponsored by the Bretton Woods Committee. Speakers included Central Bank Governors from France and Sweden, Mohamed El-Erian, Chief Economic Advisor for Allianz, as well as senior officials from the World Bank and the IMF.

Discussions were wide-ranging. From the point of view of multilateral organizations like the World Bank and the IMF, there was a surprisingly upbeat tone, underscoring the recent positive progress in global economic development, although this optimism is tempered by a number of headwinds such as economic inequality and wage stagnation.

While some countries, notably the U.S., have instigated a backlash against global trade and a retreat from active support for multilateralism, the World Bank painted a rosier picture overall, noting that most countries, particularly from the developing world, continue to be supportive of the World Bank’s programs and efforts.

In addressing the apparent disconnect between market sentiment and geopolitical reality, some interesting thoughts were raised: Would stock markets be even more buoyant absent the current global crises? Should we worry about the risk of an abrupt shock to the system?

The importance of education was addressed – particularly in less developed countries – as key to effectively leveraging the benefits of technology. Education, they argue, should focus on areas like energy, communications and agriculture, where a positive impact can be magnified and help create a real underpinning for growth. Climate change was also touted as a critical issue facing all nations. The African continent, for example, is highly exposed and is already feeling the effects of drought. Industrialized nations, the speakers warned, would do well to tackle this serious issue in the near future, or face massive migration from Africa.

With the discussion turning to global economic growth, the over-arching theme was that the global economy is in pretty good shape, despite the existence of serious challenges. In Mr. El-Erian’s opinion, “things are better, but…”, and there is a long list of ‘buts’. For instance, we understand less about advanced economies than ever. Why, for example, do wages continue to stagnate even as global growth has picked up? How is technology changing the rules of how economies function? And what are the implications of low financial volatility? This year has seen the smallest change ever recorded in the S&P 500’s volatility. Many of the speakers attributed this to the fact that in such uncertain times, investors feel reassured by the expectation that central banks will ‘have their back’.

Another problem to tackle is the fact that the world’s economies are growing at two speeds: rapid for emerging/younger economies and more slowly for the developed, western economies. The pace of each growth rate is compounded over time, exacerbating the income inequality gap. As for the challenges of technology, the banking sector—and its regulators—clearly feels pressured to stay relevant in the rapidly growing world of technological innovation. To put this in perspective, the world’s largest bank in terms of assets, China’s ICBC (Industrial and Commercial Bank of China) has only half the capital of Apple.

In Asia, business and economic integration is thriving, and China has clearly stepped up to fill the void left by the U.S.’s retreat from the global stage. The TPP (Trans Pacific Partnership), now called the ‘TPP 11’, remains alive and well despite the U.S.’s withdrawal. China is also spearheading the ambitious ‘One Belt One Road’ initiative, which plans to invest billions of dollars in infrastructure and trade routes linking 68 countries in Eurasia and the Pacific. While some are understandably wary of this grand scheme as a thinly veiled power play, it will no doubt serve to further integrate the region economically. China is also benefitting from a strong inflow of R&D dollars, with Chinese universities currently producing five times more science graduates that the U.S.

The renegotiation of NAFTA is slowly moving forward, but there are constraints, notably the presidential elections in Mexico next July and the 2018 U.S. midterm elections. Mexico’s economic success is inextricably linked to free trade, but, interestingly, only 44% of Mexico’s trade goes through NAFTA. One idea that seems to be gathering traction is to expand the Pacific Alliance trade bloc (which consists of four Latin American nations, all bordering the Pacific) to incorporate some Asian economies.

Lastly, financial reform and stability were addressed. The central question remains: ten years from the 2008 financial crisis, have reforms worked? The Governor of the Banque de France stressed that there was no doubt that the financial system is safer than it was ten years ago. As evidence, he noted that no banks failed, or faltered, immediately post-Brexit. He added that we should take advantage of the current robust economic recovery to attain three goals: preserve what we have achieved, rebalance economic policies, and gain agreement on the latest set of global banking rules (Basel III), which remains close but not yet complete. The regulatory experts stressed that financial institutions should avoid the temptation to unwind and relax the rules and regulations that have been put in place since 2008.