Outlook

01 May 2018

Q2 2018 Outlook

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By London & Capital

THE RETURN OF VOLATILITY

2018 has delivered few surprises to date; global economic growth continues, while higher inflation pushes policymakers to raise rates. Tax reform in the US should support growth, even though the threat of a trade war has taken centre stage in recent weeks. The world’s economies remain on track for the strongest synchronised growth for many years and the recent bout of volatility has not changed this outlook. If anything, investors have become less complacent and pricing more realistic. The outlook for asset markets remains positive as a result.

 

Headline positioning:

  • Fixed Income: No change to asset allocation; be mindful of duration and be selective on risk.
  • Equities: Overall stance unaltered despite market pullback.
  • Alternatives: Constructed to benefit from spikes in market volatility.

KEY ISSUES

Return of volatility – back to reality

Volatility returned with a vengeance in early February and investors have remained nervous since. There was no single catalyst, but rather a blend of factors. We have argued for some time that it would be dangerous to ignore a rise in US Treasury yields and the underlying volatility in bonds, as it influences the pricing of all asset classes. The threats in the US are reflected in market valuations, but Europe could emerge as a potential threat in the second half of 2018. Hopefully, the European Central Bank (ECB) will allow markets to adjust gradually to the normalisation of monetary policy. In the meantime, investors have become less complacent on volatility.

The end of globalisation and a potential trade war

We have previously discussed why the era of globalisation has helped give rise to populism. The financial crash created a notable change in mood, as unemployment soared and people’s wealth was destroyed. The current escalating threat of a trade war is part and parcel of this shift in sentiment. The US’s participation in the Trans-Pacific Partnership (TPP) deal has ended and the North American Free Trade Agreement (NAFTA) agreement will be amended. This creates uncertainty and fear, but it may well deliver a more balanced world and renewed trade flows in the long-term. However, any shorter-term disruption to global trade will undoubtedly be negative for growth and risk markets.

Unexpected interest rate rises

The era of emergency monetary policy is over. This is no surprise - central banks have been announcing their programme to remove Quantitative Easing (QE) for some time. Why? The global economy is stronger, banks have recovered and the threat of deflation has gone.

The threat of rapid interest rate rises is low, but the market continues to underestimate the likelihood of three further rate hikes this year, and a further three in 2019 as part of the normalisation process. This is feasible, given the boost to the US economy from the recent tax cuts.

The ECB poses a greater threat. A large part of the European bond market is now trading at a negative yield, anchored by the ECB’s policy. Any move to positive yields and interest rates will be a shock to markets and investors.

Inflation spikes – low risk event

The tightening labour markets in the major economies have so far failed to trigger faster wage growth. This would tend to imply that the traditional relationships have broken down (the dreaded Phillips curve). It could be that the unemployment rates are misleading and not a true barometer of the underlying dynamics of the labour market. It may also imply that the power has shifted away from employees to companies. We remain alert to the problem and continue to monitor changing underlying inflation dynamics.

Jump in government bond yields – a painful repricing of risk

The good news is that the most important global sovereign bond market (US Treasuries) has already repriced significantly in response to higher rates. The benchmark 10-year yield may yet rise higher to 3.25-3.5%, reflecting the normalisation of US rates and the burgeoning US budget deficit, but the biggest repricing of risk has already taken place.

However, European yields remain at depressed levels and are not discounting any material change in monetary policy. A sudden shift in Bund yields to 1% would be a shock for European risk assets and we must all be vigilant.

End of a mature economic cycle – is recession inevitable?

It is true that all economic cycles must end but this doesn’t have to be dramatic. A dramatic end is generally due to an exogenous shock – an oil price spike or a financial crash - that subsequently leads to a rising corporate bankruptcies, and slower corporate and consumer spending. The risk of such a hard landing type scenario is not zero but it is not a material threat at present. It is likely that US tax cuts and the greater buoyancy in the Indian and Chinese economies can prolong this cycle beyond this year well into 2019.

Any threat of an imminent slow-down would mean a complete reversal in monetary policy with QE and interest rate cuts. This is not a rallying call to embrace risk assets, rather to be selective when picking assets.

Political dislocation

Political instability is a reality across all major developed nations and even within leading emerging economies. In our humble opinion, the influence of globalisation for over two decades, the consequent displacement of jobs, the 2008 financial crash, the loss of wealth and the loss of perceived influence have all played a role for those who have embraced extreme politics. Recent faster growth has partially kept this in check, but the fear is that a crack in the economy could prompt a resurgence. Central banks may be forced to take the strain once again.