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The Aviva Investors House View Forum brings together senior investment professionals from across all markets and geographies on a quarterly basis to discuss the key themes that we think will drive financial markets over the next two or three years. In so doing, we aim to identify the key themes, how we would expect them to play out in our central scenario, and the balance of risks. We believe that this provides a valuable framework for investment decisions over that horizon. In the February 2018 Forum we identified the following key themes:
The extreme levels of monetary policy stimulus that have persisted for almost a decade are now being slowly withdrawn (Figure 1). Although local conditions will determine the pace and extent of the required tightening, the overall theme will be common to all major developed economies over the next two or three years. It is a reflection of improved macroeconomic conditions and represents a gradual return to, or at least towards, normality in the post-crisis world. The final destination is still uncertain, but it should be characterised by steady growth, low, positive inflation and a more conventional policy interest rate. The monetary “life support” of a range of unconventional policy measures, vital during the crisis, is now no longer appropriate and is also being withdrawn. Their legacy, in terms of central bank balance sheets, however, will be with us for some time.
The US economy healed first, so the Fed was the first to tighten policy. We now expect four rate rises in each of 2018 and 2019 which will take the key Fed Funds rate back above 3 per cent. Financial markets expect a little less than that (Figure 2). While this is lower than rates that have typically prevailed in the past, it may be close to a “neutral rate”. With inflation expected to remain well behaved, it would also be a positive real rate and should be associated with a modest tightening of overall financial conditions, something that has not accompanied the Fed tightening so far. Other central banks are expected to join the tightening cycle - the BoE this year and the ECB and BoJ in 2019, although any changes (of rates or unconventional policies) will be contingent on a continuation of favourable macroeconomic conditions.
Over the long run the appropriate level of financial asset prices will be determined by fundamental drivers. Among the most important of these are the underlying pace of growth, the prevailing rate of inflation (Figure 3 & Figure 4) and the interest rate set by the central bank. During the financial crisis and in its aftermath there was great uncertainty about where all of these would settle and this contributed significantly to financial market turmoil. Many of the unconventional policies that were adopted over the last decade were intended to provide much-needed stability and, more contentiously for some, to support asset prices in general. For an extended period of time, many asset prices were underpinned more by the policy backdrop than traditional fundamental influences. As these policies are withdrawn, the direct support for asset prices that they supplied must necessarily diminish. But the reason policy is changing is because better macro-economic conditions have returned.
Last year saw a clear change as the more customary drivers reasserted their influence on financial asset prices and we expect this to continue in 2018 and beyond. The return towards more “normal” monetary policy regimes around the world along with the restoration of an environment of low, positive inflation has already put some upward pressure on sovereign bond yields which had sunk to unprecedentedly low levels in recent years. This in turn may lead to adjustments in other financial markets. It is also plausible that there could be greater dispersion across fixed income markets as fundamentals reassert themselves, reflecting differing prospects, policy settings and economic conditions.
The period that became known as the “great moderation” (dates vary, but usually depicted as around mid-1990s-mid 2000s) was characterised by steady economic growth, low, stable inflation and a belief that boom and bust business cycles were a thing of the past. The rude awakening provided by the financial crisis understandably led to a significant reassessment. In particular, persistently low inflation and the very real threat of deflation led some to argue that inflation would now stay permanently low and that policy should, as a result, remain loose indefinitely. But the prevalence of low inflation since 2009 – even negative inflation – should not really have come as a surprise given the collapse of demand and resulting emergence of excess supply. Price pressures really should not re-emerge until that spare capacity has been used up.
We are now approaching that point globally – we may be past it in some geographies. The strong growth that we have seen in recent years is closing the gap between supply and demand and will in our view lead to a return of sustained low positive inflation in 2018 and 2019 that will converge on target rates (typically around 2 per cent). The US is most advanced in this process – it will take a little longer in the Eurozone and elsewhere. Wage inflation has also been subdued by historical standards, but this too should tick gently higher over the next few years. There was some evidence of higher inflation emerging last year, but it was not entirely convincing. It should become more clearly established this year and lead to an accompanying adjustment in inflation expectations (Figure 5 & Figure 6). Such a development would be an important element in the reappearance of more normal macro-economic conditions. A return to, and acceptance of, 2 per cent inflation would imply that a re-evaluation of yield curves and term premia could be appropriate.
One of the key messages from the 19th Communist Party Congress last October was a subtle modification of the economic policy focus away from an emphasis on growth targets and towards supply-side reforms (including state-owned enterprises or SOEs), deleveraging and the longer-term transformation of China (Figure 7). That message was reinforced more recently at the National People’s Congress. There was a growth target for 2018 of 6.5 per cent (down from the 6.9 per cent achieved last year), but previous references to “striving for better” were absent. Targets for both the broad money aggregate (M2) and fixed asset investment were also dropped, supporting the view that a rigid adherence to the achievement of targets is no longer such a priority. This being Chinese data, it would be a surprise if targets were not reached.
Arguably, being a hostage to fortune where GDP objectives are concerned has been more of a hindrance to Chinese policy as well as to its transition and economic development ambitions. The other major theme that has emerged has been President Xi’s ongoing consolidation of his power-base. Far greater prominence has been given to Xi himself rather than the Party and the state, meaning that the foundations have been laid for a long stay in office, perhaps indefinitely, a clear change from earlier precedent. This change begs many questions about a return to dictatorship, benign or otherwise, but could also ensure greater stability and progress. Xi has associated himself indelibly with reform and transition. The combination of that aspiration and almost total power may help ensure that those reform goals can be achieved.
This was also the message that emerged clearly from the 19th Party Congress in October. As well as consolidating his power-base (which should provide greater stability), President Xi modified the economic policy focus in the years ahead, away from the emphasis on growth and towards supply-side reforms (including state owned-enterprises), deleveraging and the longer-term transformation of China.
While some elements of these initiatives will take years to implement and bear fruit, others will have an impact from now on and will help define key parts of the overall global macroeconomic backdrop in 2018 and 2019.
The “One Belt One Road” set of initiatives in particular may well become increasingly important on the world stage. Although what China says and what it does can be very different things, it is an irony not lost on several commentators that China now sounds more amenable to free trade and open markets than Trump’s America.
After the inevitable raft of greater financial regulation in the wake of the Global Financial Crisis (GFC), the pace of introduction of additional measures has, just as inevitably, waned somewhat in recent years. This does not mean that we are about to experience a far looser regulatory environment in the near future, but rather that we have probably passed the peak in terms of additional initiatives being announced. Indeed, with the ostensibly market-friendly Mr Trump in the White House, there is even the possibility of a worthwhile reduction in the regulatory burden in some areas. His rollback on rules may not be as dramatic as portrayed in the campaign, but it does now look as if the key Dodd-Frank legislation will be relaxed significantly. The mooted changes in the definition of a “systemically important” bank would remove the need for 25 of the 38 largest banks in the country to comply.
Despite claims that regulation would be removed, arguably the more significant change is the large reduction in the number of new rules (Figure 8).
In Europe there has perhaps been a greater acceptance of tighter regulation and less momentum behind any moves towards a lighter regulatory touch. But it is also generally accepted that a properly functioning banking system is vital. And in this context it is widely recognised that credit needs to be made available to reputable entities that wish to borrow if the Eurozone recovery is to continue. The latest indications are that credit conditions have eased considerably since the sovereign debt crisis and that lending has picked up. Although it is unlikely to be characterised as looser regulation, the European authorities will wish to ensure that credit continues to flow, without significant hindrance, to where it is needed. When there were more worries about the fundamental health of large parts of the European banking system, this was less of a priority – at such times solvency was more important than liquidity.
Three months ago we welcomed the fact that global trade tensions had moderated. That may have been a false dawn. Perhaps we should not be surprised, given the stress that the Trump team placed on the issue during the election campaign, that protectionism is very much back on the agenda following the provocative imposition of US tariffs and reciprocal measures from China. The risk of a more damaging trade war or wars is clearly evident, threatening global trade (Figure 9). The potentially disruptive risks of nationalism and populism continue to bubble beneath the surface in many arenas including European elections, Trump policy and Brexit negotiations. They may yet resurface more alarmingly, especially if economic fortunes change for the worse.
The trend rate of GDP growth in China is slowing, as it is in many countries (Figure 10). But China’s size and importance mean that both its growth rate and how the trend slowdown is managed will have ramifications for both financial markets and the global macroeconomic outlook. China is attempting to transition to a more open, service-based economy. But the combination of the inexperience of its policy-makers, their determination to micro-manage every detail of the economy and society, their ambitious long-term aspirations and China’s strange demographics means that the scope for upsets and mistakes is significant. There have already been previous episodes of China growth worries that have rattled global markets. An unnecessary slowdown could be brought about either by a transition shock or as a result of policy mistakes. Either way, it would be foolish to ignore the risk of more shocks in the future.
Tightening cycles have barely begun in some places but so far central banks (CBs) have merely been “leaning into the wind” and it has been noteworthy that overall financial conditions are looser today then when the Fed first raised interest rates in December 2015. The favourable policy backdrop has finally resulted in a marked pick up in global growth. The “gradual and limited” playbook of CBs today is generally well understood. But this would change dramatically if they instead determined that they needed to slow growth deliberately – to actively tighten financial conditions – perhaps to ward off inflationary pressures. The pace of tightening has until now been easily the slowest in the post-war period (Figure 11). A simple reversion to an “average” rate of hiking would change the financial market environment profoundly.
The long period of exceptionally low interest rates encouraged greater borrowing, just as it was intended to do. Debt levels around the world have risen as households, companies and governments all borrowed more. As interest rates now rise, even if they do so only very slowly, it is inevitable that the costs of servicing those debts will increase and that the debt burden will become incrementally more onerous. Credit conditions, as gauged by loan covenants, have eased significantly in some areas (Figure 12). How different debtors cope with these changes will help determine the resilience of the recovery. We do not anticipate that borrowing costs will get even close to rates that prevailed in the past, but history is littered with examples of borrowers who hadn’t realised they were overextended until rates rose. Gearing is undoubtedly higher today in some areas. As interest rates now rise gently, there are obvious risks that such vulnerabilities will be exposed.
2017 was a good year for the Eurozone. It saw the strongest growth for a decade and an expansion that was extremely broad-based. Differential growth rates have in the past been a source of tension between member nations. In addition, the French and German elections passed without too much drama and resulted (eventually in the German case) in governments that should be able to take further steps on the path to closer integration. The recent Italian election has been a little bit of a setback and it remains to be seen whether any sort of government can be formed. But it should not go unnoticed that all three elections featured significant support for nationalist and populist movements. Meanwhile, clear, definitive progress towards fiscal and political union is still painfully slow. This scenario is an upside risk for Europe, but looks as distant as ever, perhaps more so than three months ago.
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