The global economy’s ongoing expansion continues to underpin the current equity bull market, which is already one of the longest-running in history. We do not expect this dynamic to change in the short term, but there are shifts occurring within the economic backdrop which warrant monitoring for signs that the investment environment may be beginning to deteriorate. In this article, we identify some of the key areas where adverse developments could have some of the greatest market impacts.
Growth should remain robust in the world’s most important economies through the rest of 2018
We expect the US economic cycle to extend as a result of the tax reforms introduced by the government earlier in the year, which are boosting corporate investment and supporting job growth. In Europe, growth slowed in the first half of the year as a result of transitory headwinds such as adverse weather conditions, but significant spare capacity still remains within a number of the region’s underlying economies and this should allow its expansion to continue for some time. Meanwhile, China’s growth rate should continue its managed slowdown in the second half of the year as the effects of slower credit expansion are felt; however, we expect its economy to avoid a ‘hard landing’ as the Chinese government is well aware of levers it can pull to support growth as it tackles the economy’s structural headwinds.
However, the potential for a growth slowdown presents a key risk to investment markets over longer time frames
Despite the fact that we expect it to extend, the US economic cycle is more mature than those of the other major regions and its economy will eventually begin to experience cyclical growth headwinds. There is some uncertainty around how much slack remains within the US labour market, but employment growth will eventually slow and this could damage investor sentiment. This would be particularly harmful if investment fails to support productivity growth. There is also a risk that China’s government will allow growth to slow more quickly than expected. Infrastructure investment has already slowed sharply as the government has sought to control the rate of credit creation and although monetary and fiscal stimulus have been provided to support growth under similar circumstances in the past, there is no guarantee that this will continue indefinitely. Ultimately, China’s current growth rate is unsustainable over the long term.
Market pricing suggests that inflation will remain under control, even in the US where it could temporarily rise above the Federal Reserve’s 2% target
Inflationary pressures have built in recent quarters, particularly as oil prices have increased. However, policymakers are likely to look through transitory factors such as rising commodity prices. There are still various structural factors holding inflation back and these are perpetuating the view that the world will remain within an environment of secular low inflation. Such factors include technological advancements such as internet retail (which improves price transparency and comparison), demographic changes which are causing a savings glut, high debt levels in both the private and public sectors, and the globalisation of labour markets causing the relationship between employment and inflation to break down on a regional basis.
However, the current environment of secular low inflation may not persist indefinitely…
Nevertheless, it remains to be seen whether US wage growth will accelerate more quickly once the current rise in the participation rate slows, as regional labour shortages could develop. Likewise, other regions, such as Europe, will eventually see their labour markets tighten and this will lessen the deflationary effect of workforce globalisation. Furthermore, various political events have shown that electorates around the world have become fatigued with belt-tightening austerity policies and there is potential for more expansionary fiscal policies to be enacted which will raise developed-world demand. This has already been seen in various regions; in the US with their recent tax reforms, in the UK where political pressure caused the Chancellor to adjust his attitude to spending in the last budget, and in Italy where a populist coalition has entered government and promised to increase spending.
…and this presents a key risk for asset markets
With consumer inflation quite subdued, a spike in inflation would have a dramatic effect on policy expectations. Such an event would be likely to drive a sharp increase in long-term bond yields, which would have follow-on effects on asset prices in general. While this is not our central case, it remains a key risk; it is prudent to remember that the sharp correction that occurred within equity markets in the first quarter of this year was catalysed by a stronger-than-expected US wage growth data release.
To date, markets have shown resilience as central banks have started removing some of their monetary policy stimulus measures
With the ongoing global economic expansion maturing, some of the world’s major central banks have begun adjusting their policy stances. The Federal Reserve has led the way, having already raised US interest rates seven times and begun reducing the size of its balance sheet. However, the European Central Bank has also announced plans to stop purchasing assets by the end of the year as the threat of deflation has diminished on the Continent. Together, these changes have been key drivers of the rise in yields that has occurred in recent years. Furthermore, liquidity in fixed income markets will continue to decline as global central bank policy shifts further from quantitative easing towards quantitative tightening.
Expectations that inflation will remain under control have helped contain the rise in bond yields
While yields have risen, the ten-year treasury yield remains around the key 3% psychological level above which many investors will consider the multi-decade fixed income bull market that has been underway since the 1980s to have ended. As such, the broad fallout from the contribution of higher yields and lower liquidity has so far been relatively muted in terms of the effect on equity markets. We believe this situation could change if ten-year treasury yields were to stabilise above 3%, as this would raise the possibility that yields could potentially move materially higher. In such a scenario, debt refinancing costs would rise sharply, particularly as corporate bond spreads are already low and therefore less able to absorb further rises in government bond yields.
Any change in this expectation could cause US monetary policy to tighten further, putting pressure on growth
Nevertheless, we do not expect treasury yields to increase significantly unless investors become convinced that inflation is moving persistently higher. However, this situation has its own risks; if changes in global central bank policy cause short-term interest rates to move above longer-term treasury yields, the treasury yield curve would have ‘inverted’. If this occurs, it would break a fundamental function underpinning the working of the banking sector; banks won’t make the loans that a healthy economy needs to function when the short-term rates at which they borrow are higher than the long-term rates at which they lend. Such a situation would therefore have a negative impact on credit growth and is generally a reliable indicator that a recession is forthcoming.
Such a situation could also have destabilising effects around the world via further appreciation of the US dollar
Another contributing factor to the tightening of global financial conditions has been the recent strength of the US dollar, which was driven by a shift in economic momentum towards the US from overseas. This has had a pronounced effect on the relative performance of emerging market assets relative to their developed world counterparts, as a stronger dollar makes it more expensive for emerging market countries and corporates to finance their dollar-denominated debt burdens. The repercussions have been particularly significant for countries which are considered most vulnerable to external shocks, such as Argentina and Turkey, which have seen their currencies devalue sharply.
For UK investors, Brexit still represents the most pertinent risk.
Not only will the outcome of the Brexit negotiations affect the UK’s economic prospects for many years to come, but perceptions of how the process is playing out will have significant repercussions for sterling exchange-rate volatility and, therefore, sterling-denominated investment returns. Although the situation is riddled with uncertainty and remains highly unpredictable, episodes of volatility are likely to present active investors with attractive investment opportunities.
To date, the threat of trade protectionism has largely been contained to rhetoric, but it presents significant economic risk
The threat of trade protectionism has been headline news this year, with China, the European Union and the US, in particular, escalating their rhetoric surrounding the introduction of import tariffs. While President Trump has stated that the US’s tariffs are simply designed to repatriate economic activity that has left the US for overseas, we believe his decisions are indicative of a desire to maintain the US’s global economic dominance, particularly over China. Tariffs have the potential to disrupt supply chains, thereby impacting economic growth; they could also have inflationary implications and consequences for global monetary policy. So far, the impact of trade tariffs is yet to be felt, but if recent rhetoric is to be believed they hold the potential to create significant growth headwinds in the future. The problem is, no-one can be sure exactly what the impact will be as it is uncertain what the shape of future trade arrangements will look like, or even if protectionist policies will simply be contained to trade tariffs. It appears that China is already devaluing the renminbi to offset the potential implementation of trade tariffs; the last time it did that to support growth at the start of 2016, investor sentiment was damaged and global equity markets suffered a significant sell-off.
Europe’s structural issues remain, but its governments and policymakers have succeeded in preventing any systemic breakdown
On the Continent, Italy’s new coalition government’s spending plans seem to have put it on a collision course with Brussels over the Italian budget, which is due to be delivered on 20 September. The situation has already had a significant effect on the country’s sovereign bond markets, with yields on Italian government debt jumping in May. This will make it harder for the country to reduce its large debt burden, which makes it vulnerable to a slowdown in growth. Unfortunately, Italy is just one example of many countries and companies that have perilous debt burdens; indeed, an escalation of risk in this area could potentially catalyse another European sovereign debt crisis similar to that which occurred in the years following the global financial crisis.
Both the economic environment and investment backdrop remain supportive of asset prices, but as the major regions’ economic cycles mature the risks to our outlook will gradually intensify. While it is not always a known risk that causes a bull market to reverse, we will be monitoring these key areas for signs that the environment is deteriorating. For now, we continue to favour equities over fixed income as the corporate operating environment remains accommodative, but we have also incorporated balance within investment portfolios to reduce risk; specifically, this has involved diversifying into areas such as alternative assets.
This article was first published by Brookes MacDonald 0n 30th July 2018.