At times like these, it’s always good to remind ourselves of the underlying fundamentals that should ultimately be the driver for markets. The economic regime during the past year has been one that some term as ‘goldilocks’, one where policy can remain supportive of growth as inflation remains low and output gaps remain negative, further reinforced by an easing of financial conditions through wealth effects.
The second half of 2017 was particularly pleasing for the growth outlook given the broad-based nature of the recovery, across regions and sectors, boosted by global trade and capex cycles picking up. Risk assets, not surprisingly, perform particularly well in this type of environment, and indeed can become expensive as volatility remains low whilst the growth outlook brightens and inflation remains subdued.
The US experience in 2017 was particularly interesting. Financial conditions in the US actually weakened as global growth became synchronised, driven particularly by a weakening USD and stronger equity markets, despite the 75bps of tightening by the Federal Reserve in 2017. And so we entered 2018 on a wave of exuberance, with the market pricing in higher inflation and a higher risk of tighter monetary policy particularly in the US, which in recent days been reversed, as government bonds, credit spreads and equities have all experienced poor returns.
Shifting regimes due to a higher probability of tighter policy drives volatility and risk premia higher. Our regime analysis suggests we’re in an environment that remains supportive for risk assets. Nonetheless, with a higher probability of cyclical inflationary pressure, and hence the risk that central banks drive financial conditions tighter, the market requires an adjustment for this stage of the cycle. As the market shifts its expectations between easy financial conditions to tighter financial conditions, risk premia in risk assets must be repriced, and indeed that is what we are seeing at present. Higher volatility will continue as riskier assets become less attractive versus bond yields and the market considers when the end of the cycle may occur.
The underlying fundamentals remain supportive for higher yields globally and risk assets as we look ahead to Q2, with assets experiencing low returns.
Growth remains synchronised and broad based. There is little to suggest that a recession is imminent. No doubt, macro imbalances and risks remain but the tail risk of poor growth and deflation is as low a probability over the next six months as it has been for many years. The pressure for global yields remains higher but is more likely to be driven by short to mid curve bonds as the cyclical inflation outlook becomes more certain in those countries experiencing a closing of output gaps. Credit remains attractive as it offers premia above what is suggested by the expected defaults, but with spreads as tight as they are, we remain with our lowest credit exposure for a number of years, dominated by high-quality names, owning credit for carry rather than spread compression. Nonetheless, we don’t see a default cycle picking up at this stage of the cycle globally, and any market repricing based on higher volatility, we will consider an opportunity to rebuild our credit exposure. It is worth noting, though, given the amount of cash that has been driven into the markets, that market repricing may go further and be more aggressive than expected.
Active management that takes advantage of opportunities within key markets should be a much larger percentage of total returns in this environment.
The timing of output gaps closing will differ across economies, and require differing policy action across central banks, given the different approaches that central banks have taken through the easing cycle. This should provide greater opportunity for relative value trading opportunities across countries and yield curves. Delving into how inflation and real yields are being priced across the nominal interest rate curve can uncover insights and opportunities.
Despite some concern of a flattening yield curve in the US in 2017, signalling the end of the cycle, break even inflation, the market’s expectation of inflation, continued to rise, suggesting risk assets could continue to perform and that the Federal Reserve was behind the curve rather than getting ahead of it. The same can be said of credit markets. With credit spreads so tight, the carry return can be wiped out easily by a move higher in credit spreads, or a portfolio that experiences a default. Holding credit exposure that you have confidence in not defaulting, and choosing names that you expect to outperform, can reduce the volatility to returns that can occur when credit spreads are tight.
Some clouds to our silver lining
Given the positive growth outcome has been synchronised and supported by a recovery in global trade, a downturn is also likely to be synchronised. This is quite different to the experience of the prior five years where economic cycles were desynchronised leading to lower global growth but with lower volatility. Furthermore, if we were to see a slowing in growth but it was still robust enough to close output gaps and keep pressure for higher inflation, this would be very challenging to risk assets and bond markets.
The risk of mistakes is also much higher given the unconventional nature of policy and the lack of experience in unwinding it. This is complicated by ongoing structural forces remaining a cap to inflation, and potential growth levels. Future ECB and BOJ policy actions will be definitive in this respect.
IIan Dekell is Head of Macro at AMP Capital.
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