Download Aviva Investors House View Q3 2018
This publication is in PDF format - For iPad users, save to iBooks for the best reading experience (7.1 MB)
8 minute read
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 May 2018 Forum we identified the following key themes:
World GDP is estimated to have grown by 3.8 per cent last year, the strongest outturn since 2011. We expect growth this year to be a touch higher, pushing towards 4 per cent and 2019 should see something similar, even while monetary stimulus is slowly withdrawn.
Our projections are slightly above consensus numbers. Moreover, growth has become increasingly widespread, with almost all nations benefitting from the cyclical global upswing (Figure 1). Advanced nations should see GDP expand by around 2.2 per cent, while for emerging and developing nations the figure should be close to 5 per cent. A decade after the Global Financial Crisis (GFC), the world is finally expanding at a pace comparable to the average seen between 1960 and 2007.
After a number of false starts since 2008, it is now generally accepted that positive economic growth is the normal state of affairs, even if the sustainable pace of that growth may well slow in future years as a consequence of demographic change and, more debatably, weaker productivity growth.
If growth continues and the crisis drifts back into history, some of the legacies of that episode will fade further, allowing policy settings to begin (or continue) their slow journey back towards “normality”. As conviction in an ongoing expansion has grown, it has been noticeable that investment spending has made an increasing contribution (Figure 2). This bodes well for future growth and, perhaps, for productivity improvements. In and of itself, the strong growth backdrop should be a helpful one for risk assets.
During the GFC and in its aftermath there were genuine worries that deflation was a clear and present danger. As economies have recovered and reabsorbed idle factors of production (labour and capital) back into use, such fears have abated. It comes as no surprise to us that this has taken a long time: underlying inflation is fundamentally a consequence of demand pressures on supply capacity.
The conditions of excess supply that have prevailed over much of the last ten years imply an absence of inflationary pressure. That is now changing as demand has recovered and output gaps (the difference between supply and demand) have narrowed or even closed completely in some cases (Figure 3).
With above-trend growth set to continue in 2018 and 2019 too, inflation should make a more determined return towards levels more in line with central bank target rates, typically about 2 per cent.
Some countries – the US for example – look already to be at or possibly even beyond this point because their cycle is more advanced. But sustained, positive inflation is likely to be a theme that will characterise the investment backdrop for the next couple of years at least.
In tandem, inflation expectations should become more embedded at rates compatible with those inflation targets. Indeed, this is already happening in several countries (Figure 4). It is worth noting that inflation has returned least convincingly in those nations where the recovery after the GFC took longer to establish itself (Eurozone, Japan).
As he attempts to deliver on “America First” campaign promises, President Trump has looked to radically change the terms on which the US engages in global trade. From withdrawing from the Trans-Pacific Partnership to renegotiating NAFTA and targeting steel and aluminium imports, the US has more recently moved on China through a threat to impose tariffs on a wide range of goods in response to alleged theft of intellectual property. Investigations have also been opened into the auto industry and potential for tariffs there as well.
Whether these latest threats prove to be part of a negotiating strategy that will ultimately deliver concessions from China or rather lead to widespread tariffs being imposed by both parties (and potentially others) in a tit-for-tat trade war remains to be seen (and is reflected in our key risks).
But even if a more positive outcome is achieved, the path to get there is likely to be difficult. For that reason, we expect it to remain at the forefront of investors’ minds over the year ahead. Adding to the challenge for markets is that there is little doubt that Trump is playing to his home crowd, with one eye on the November mid-term elections. The tariffs issue polls very well with the domestic audience. But as the recent US – North Korea summit demonstrated, Trump can turn from insult to deal very quickly.
The extraordinary period of extreme policy stimulus that has existed around the world since 2009 is coming to an end (Figure 5). During the period that became known as the “great moderation” (steady growth, low and stable inflation), the idea that policy interest rates would go to zero or below and that central banks (CBs) would engage in massive purchases of government bonds would have been considered far-fetched to the point of being preposterous. But that is what happened, and while opinion still remains divided about whether it was the right thing to do, we believe that these extreme actions were necessary in the circumstances.
Whether such deeds helped bring about the return of both growth and inflation or not, the fact that both are back with us means that CBs are right to be withdrawing monetary stimulus. They are also sensible to tread carefully while doing so.
The timing of tighter policy will vary depending on conditions in individual countries or regions. An estimated $12 trillion of QE assistance has been provided so far (Figure 6). The US has already halted asset purchases (and reinvestment) and raised the Fed funds rate six times. We expect a further two hikes this year and an additional four in 2019.
The next few years will see more follow their lead as policy interest rates very slowly move back towards (but probably not to) rates that have prevailed, on average, in the recent past. The Eurozone has reduced the pace of asset purchases and plans to halt altogether this year before raising rates in 2019. The situations in Japan and the UK are more problematic because of the special contexts of serial macroeconomic disappointments and Brexit respectively. But over our two- to three-year horizon an upward bias to monetary policy is likely.
Higher policy interest rates are appropriate in a world where growth and inflation have been restored. But in addition to the specifics of tighter monetary policy, financial markets will now also have to get used to the absence of Quantitative Easing (QE).
Stressing this difference is not semantic; QE has had huge impacts on the prices of financial assets since it was first introduced in 2009 and this continues to today. Indeed, current policy from both the European Central Bank (ECB) and the Bank of Japan (BoJ) is still having direct (some might say distorting) effects on asset prices. The transmission mechanism for QE is poorly understood, but a substantive part was exactly that – to boost asset prices and help generate beneficial wealth effects and portfolio substitutions.
Financial markets will now have to adapt to a world without such an influence (or at the very least, on a much-reduced scale). To some extent they have already started to do so – part of the explanation for higher sovereign bond yields in 2018 (Figure 7), for example, is that CB buying is much lower today. The policy was intended, again in part, to suppress yields, so the absence of QE implies that they will now have to find their own level. But there will be knock on effects to all financial assets as institutional investors rebalance portfolios to better reflect market conditions free from what some have termed the artificial stimulus of QE.
2017 saw a collapse in cross-asset volatility to historically very depressed levels. Although periods of low asset price volatility are common during times of economic expansion, those experienced last year were exceptional in both level and breadth of assets affected. While we see no evidence of a notable slowing in global growth, which is the usual prerequisite for a structural and sustained elevation in cross-asset volatility, there are a number of reasons why we anticipate higher levels than those seen last year.
The accommodative investment environment that was engineered by low policy rates, QE programmes and central bank communication have all had a profound effect on the suppression of volatility. As interest rates rise in response to more sustained inflation, this volatility suppression is also being wound down. The US is further through its economic cycle than other global economies and the tightening in policy rates that are appropriate to it will continue to have a variety of knock-on effects to other economies across the world. This has been acutely seen so far this year in certain Emerging Market countries, such as Argentina and Turkey, which have witnessed extreme levels in currency and rates volatility.
As the US continues to tighten, this is likely to keep volatility higher than levels that investors have grown accustomed to over previous quarters. Even in core asset markets we expect that ultra-low levels of volatility reached last year will not be retested. This is a natural process over time and one that might occur, potentially (perhaps on a lower scale), even if the cycle were to show no sign of slowing.
The risk of damaging trade disruptions, largely as a consequence of President Trump’s actions on tariffs, remains significant. Like many of his initiatives, it is difficult to establish how sincere and determined he is on any announced actions. But his recent restatement of tariffs on steel and aluminium is a signal that further trade skirmishes are plausible – reciprocal actions from China and/or Europe seem likely. Trump’s latest announcements were met with universal condemnation around the world, but it sometimes appears that this merely encourages him.
The pick-up in world trade growth in the last two years (Figure 9) has been a pivotal part of the economic recovery that is now threatened by these initiatives. More generally, populism and inward-looking nationalism continue to influence politics in many areas.
Although annual GDP growth in China has been remarkably stable at between 6.7 per cent and 7.0 per cent over the last three years, the underlying pace of potential growth continues to slow (Figure 10). The growth target for 2018 is 6.5 per cent and that is likely to be achieved with some comfort.
But in future years it is going to be lower. That is inevitable, but how the process is managed is critical, as are the cyclical influences around the longer-term structural trend. No country has been through the transition from emerging to developed economy without bumps along the way. China’s policymakers are inexperienced and determined to micro-manage every detail of the economy and society. Mistakes will be made. China is now a major world player and any growth concerns or policy errors have the capacity to rattle world markets.
Overall financial conditions in the US are looser today than when the Fed first raised rates in December 2015. They have at least tightened so far in 2018.
Headline CPI inflation has reached 2.5 per cent and core is now above 2 per cent. Both are expected to move higher. Were the Fed to start to get more nervous about inflation, either because of these trends or those in the labour market, then their playbook could change to one that attempts to slow growth more deliberately to choke off inflationary pressures. In such circumstances, they might decide they had to move above neutral, possibly quite quickly. A change to more than four rate rises in a year would be a significant alteration of the Fed stance and expectations regarding its actions.
This is a subtle variation of the previous risk. In this instance the Fed instead ignores potential inflation risk and sticks to the “slow and gradual” approach on interest rates. Growth momentum would be maintained or increased and both inflation and financial stability risks would intensify considerably. As the US economy began more visibly to overheat and the recognition of a policy error grew, the Fed would have to change course, hike aggressively and thereby usher in a sharp downturn.
Previous downturns have all been preceded by hiking cycles (Figure 11). This scenario would almost certainly be associated with some jarring adjustments in financial markets.
We have now had a decade of exceptionally, historically low interest rates, a period long enough to have influenced behaviour meaningfully. This extended period may also have led borrowers in some areas making judgements about what represents a “normal” interest rate and debt servicing obligation.
As interest rates now rise, there are risks that the vulnerability of such groups is exposed. Low interest rates have undoubtedly encouraged greater borrowing and debt levels in several areas are markedly higher. We would highlight specifically concerns for certain US corporates, Emerging Markets that rely on US dollar funding and peripheral G10 property markets. The most indebted governments should also not be ignored. US corporate debt as a proportion of GDP, for example, has returned to all-time highs (Figure 12).
The authorities have introduced a raft of new regulatory requirements since the GFC. The indirect impact of some of these measures has become more apparent in recent years.
For instance, new capital rules have seen banks retreat from certain risk-taking activities. That has resulted in sharply reduced levels of liquidity in some markets, particularly in certain areas of fixed income, such as high-yield debt. If these influences intensified or if regulation became more invasive, liquidity in key markets could become more profoundly compromised. This, potentially, would make it appreciably riskier to invest in these asset classes than was previously the case.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). As at 30 June 2018 unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.
In the UK & Europe this material has been prepared and issued by AIGSL, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority.
In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.
In Australia, this material is being circulated by way of an arrangement with for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd (AIPPL) does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000, Australia.
The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly-traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.
WA01423 06/2018 (3 of 5)