The six key themes and risks which our House View team expect to drive financial markets.
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 February 2019 Forum we identified the following key themes:
- Economic cycle extension
- Monetary policy re-set
- Trade truce
- Brexit and European politics
- Fiscal activism
1. Economic cycle extension
The current global economic expansion is already one of the longest in the post-war period. There have been some significant regional variations, but essentially it began in the second quarter of 2009, meaning it is now almost a decade long.
Using the US as an example (as historically most global cycles reflected coincident regional and national cycles) the average length of upswing since 1945 has been just 5.5 years; if we confine ourselves to the period from the early 1980s, it has been 8.5 years (Figure 1). But there is no “natural” length. Cycles don’t just die naturally of old age – they are typically killed off by economic imbalances, tighter policy or major shocks.
Figure 1. US GDP growth and NBER recessions
The ultra-cautious approach to tightening being adopted by central banks (CBs) in the wake of the Global Financial Crisis, alongside reduced private sector imbalances and the absence of any serious inflation pressures, means that the current cycle may well be extended throughout 2019 and 2020, perhaps even longer.
The fiscal boost to the US economy will fade this year, but growth looks set to remain satisfactory, while the troubling slowdown in Europe should first stabilise and then reverse modestly. If the stimulus that Chinese authorities are currently providing bears fruit, as we expect, then the growth impulse and momentum for the world should be sustained over the next couple of years (Figure 2).
Figure 2. Global growth and IMF forecasts
Eventually another downturn and/or recession will materialise, but it does not look imminent. Doubts about where the “new normal” is for neutral interest rates imply that CBs will continue to be extremely circumspect about tightening monetary policy and while inflation remains contained (and in the absence of exogenous shocks), they will be right to act in this way. We will probably continue to see growth divergences, but overall the global economic cycle should extend for some time yet.
2. Monetary policy re-set
Over the last three months policy makers across the developed world have put more weight on downside risks to both growth and inflation.
A year ago, most had been either tightening monetary policy, or preparing the ground for doing so. Even those that had raised policy interest rates had been doing so at a historically slow pace. Although many have yet even to begin hiking, the re-assessment of risks has brought about a re-set for monetary policy as the next possible moves are considered.
The removal of extreme levels of monetary accommodation will now take place at an even more gradual pace as a result. To the extent that the delivery of, or anticipation of, tighter policy was acting as a headwind for certain financial asset prices, the recent change to a more cautious approach has, and should continue to, provide support to those same assets.
Having raised US rates once a quarter throughout 2018, the Fed has signalled a pause, with patience being the main message now. Even if they were to return to additional modest hikes later in 2019 or in 2020 – something that markets do not believe is likely – concerns that the Fed might over-tighten have diminished significantly (Figure 3).
Figure 3. Policy interest rates in major nations, and market expectations
Other central banks have also softened their stance on actual or expected policy tightening over the next few years, with most citing downside risks, either to their own or the global economy, as the justification.
After three years of sequential upgrades to global growth projections, it is noteworthy that the last three or four months have seen modest downgrades from organisations such as the IMF and the OECD. These do not automatically mean a nasty downturn is coming, but they do indicate a change in trend that provides an evolving backdrop for financial markets.
3. Trade truce
Trade tensions, primarily focussed on the relationship between the US and China, dominated the investment landscape in 2018. In each of the twelve months to February 2019, the BAML survey of global fund managers showed this issue was the single most important investment risk for respondents.
It was overtaken in March by China economic slowdown. The spectre of additional tariffs, a re-escalation of trade skirmishes or a re-focussing of Trump’s ire to other areas or regions (see risks section below) are all still possible, but the toxic environment that prevailed throughout last year has improved significantly over the last couple of months. Trump will no doubt present any deal brokered with China as a major breakthrough due entirely to him.
Negotiations between China and the US have been constructive and made important progress on the legitimate grievances against Chinese trade practices related largely to protection of intellectual property rights and improved access to their domestic markets. The ultimate proof is in changed behaviour rather than just promises, but the better mood is welcome.
Tangible progress such as the postponement of the planned increase in tariffs is helpful and should facilitate a stabilisation or even an improvement in world trade growth, which slowed sharply last year (Figure 4). If the threat of ongoing trade disruptions has genuinely receded, then the global economic outlook would be enhanced significantly, especially for open trading nations such as most of Europe and Asia.
Figure 4. World trade volumes, y/y, 3mmaFigure
4. Brexit and European politics
The cloud of Brexit has hung over Britain and, to a much lesser extent, Europe, for the last three years. It has contributed appreciably to markedly weaker growth in the UK and to the gloomier sentiment among both businesses and households.
The negotiations between the UK and the EU have at times been farcical, with the UK making unreasonable demands and empty threats from an extremely weak bargaining position. This has been compounded by bitter infighting within the governing Conservative party and a hapless and divided Labour opposition.
The resultant political scheming has ensured an almost total stalemate to what should have been the Brexit endgame. Even if some sort of deal is cobbled together, negotiations will continue for at least the next two years and are certain to influence the market, social and political mood over that timeframe and beyond.
In one sense, Brexit is simply the most striking example of what can happen if populist movements are given the opportunity to voice their dissatisfaction. Support for such movements across Europe has grown steadily over the last 40 years (Figure 5).
Figure 5. Average share of votes for populist parties 1980-2018
Deep-seated frustrations have simmered not far below the surface across Europe over the last ten years or more, erupting at times to wreak havoc on the status quo. The most recent example was Italy and its fiscal battle with the European Commission.
The drivers of such discontents are wide and varied, but many have their roots in a belief that parts of society have not participated sufficiently in economic progress and development.
Within the euro zone, critical tensions remain between the central single currency collective and the individual nation states. With political/fiscal union still some way off, this theme will continue to impact Europe over future years. Frictions are more likely to emerge if there is another economic downturn.
5. Fiscal activism
In the ongoing debate about austerity, it is often forgotten that in the aftermath of the Global Financial Crisis in 2008/9, fiscal policy provided a huge stimulus to all of the affected economies around the world.
Part of this was a result of automatic fiscal stabilisers kicking in, exactly as they are supposed to do. But part was because of direct major tax and spending initiatives with the intent of offsetting at least some of the collapse in private demand by substantial boost in public demand.
The legacy of these actions was a huge build up in public deficits and debt. Once economies were out of immediate danger, addressing these imbalances was unavoidable. Economic recovery helped in this process, but fiscal policy was a handbrake on growth for several years (Figure 6).
Figure 6. G7 actual budget balance, percentage of GDP and IMF forecasts
That lengthy period of healing means that public finances are now in far better health. Although debt remains high, it is generally affordable with low interest rates.
Meanwhile, deficits have shrunk from peaks of up to ten per cent of GDP or more, to two or three per cent in many countries and even surpluses in others. There is now room for fiscal stimulus. With monetary policy pushing against its limits, fiscal could be a viable alternative. The growth of populism and increased attention on inequality and other perceived social injustices has also contributed.
The US acted first: Trump’s tax and spending package boosted American economic growth significantly in 2018. China is another country which has recently adopted fiscal stimulus measures (Figure 7). Other nations may choose to follow, although perhaps not to such an extent. The recent experience in Italy is just one example.
Figure 7. China, IMF WEO, estimate
It is quite plausible that more activist fiscal policies will be invoked to enhance GDP growth over the next two or three years, especially if any cyclical slowdown materialises.
Cross asset volatility has itself shown a high degree of volatility over recent years, characterised by extended periods of relatively benign price moves, interspersed with episodes of relatively large asset price volatility. This pattern has been observed increasingly in different markets including equities, commodities and government bonds. Despite efforts by central bankers to extend the economic cycle, which we expect to be ultimately successful, we expect to see this pattern continue.
Extremes in cross-asset volatility occur at the ends of economic expansions when growth begins to slow meaningfully. Equity volatility is generally the first to exhibit persistently higher levels of volatility at such times, but historically also shows increasing levels of volatility in the second half of expansions.
While we think the current cycle will persist for some years to come, the structure of markets has changed considerably since the Global Financial Crisis and the predominance of non-discretionary flows and share buyback programmes are frequently the marginal buying forces. These have helped to perpetuate upside market moves whilst limiting the volatility exhibited, which is further reinforced by increasingly large waves of short-dated option selling as risk-taking sentiment coalesces.
Such forces help to provide significant downward pressure on volatility, which becomes self reinforcing as the low volatility period progresses. The market impact of crowded position de-risking and closing out of short volatility positions has recently been accentuated by the dearth in trading liquidity, contributing to spikes in volatility that are large in comparison to the conditions that preceded them. We feel this pattern of long periods of low volatility interspersed with significant spikes will continue (Figure 8).
Figure 8. S&P 500 30-day realised volatility
Risks to the house view
China stimulus fails
Will the world catch a cold if China sneezes?
China appears to be embarking on its own version of Mario Draghi’s “whatever it takes” approach to policy intervention. In the face of evidence that growth in China was slowing more than the authorities were prepared to accept (Figure 9), China has provided extensive monetary and fiscal stimulus. But it is still possible that their efforts fail and that a negative Chinese growth shock permeates around the world.
Another variant is that stimulus inflates dangerous asset bubbles rather than the real economy and condemns the country to some even more grating adjustments in the future.
Figure 9. China: infrastructure and social financing have slowed
Fed has moved too far
The Fed may already have moved above the new neutral
In the post-financial crisis world there has been considerable debate about the neutral or equilibrium level of policy interest rates. There is general acceptance that it is significantly lower than the past (Figure 10). It probably also varies across different countries. US interest rates have been raised eight times since December 2015, but are still very low by historical standards.
Nevertheless, it is not impossible that they have already moved above neutral, but that the resulting slowdown has been masked by the fiscal sugar-rush. As that now fades, US growth could slow alarmingly, pushing the economy to the brink of recession and obliging the Fed to backtrack swiftly and provide renewed stimulus.
Figure 10. Neutral and actual real rates
Upside inflation surprise
Return of inflation would oblige the Fed to tighten
The period of Fed hikes until the middle of 2018 was, in general, accompanied by gently rising inflationary pressure. Wage inflation continues to tick slowly higher (Figure 11), but CPI inflation dipped in the second half of last year, helping fuel the debate over whether the Fed should pause.
With unemployment still well below most estimates of the natural rate, cost-push pressures could re-emerge more conspicuously, leading to higher core and headline inflation and compelling the Fed to raise interest rates more sharply.
A return to “old-fashioned” inflationary overheating may seem far-fetched to some, but there is a risk that the earlier deflationary threat has led to a degree of inflation complacency.
Figure 11. US wage growth
Debt servicing strains
Excessive debt can build up insidiously
No-one should be surprised that ultra-low interest rates around the world have encouraged greater borrowing. That is exactly what they were intended to do.
Equally inevitable, as we move slowly away from the backdrop of extreme stimulus, was the revelation of where debt build up had been “excessive”. Although there has been extensive deleveraging in some areas, it is no surprise that certain businesses and households (perhaps even some governments) may have taken on too much debt and that these vulnerabilities are only now being exposed. The example of the Australian housing market (Figure 12) might just be the first to appear, but these episodes usually throw up surprises.
Figure 12. Australia, median house prices, Sydney
Trade dispute turns to Europe
Trump turns on Europe
There is a danger that Trump’s interpretation of the extended trade spat between the US and China last year is that bullying works. If so, his administration may turn its sights towards Europe.
The autos sector is the main focus of attention. In the middle of 2018, Trump threatened (via a tweet) to put 20 per cent tariffs on European auto imports. His stance contrasted with the more conciliatory approach adopted by others in Government and he subsequently seems to have abandoned such ambitions. But his latent unpredictability means the issue should not be disregarded. It may be low probability, but the impact would be enormous, perhaps ushering in greater protectionism around the world.
Smoothly functioning markets rely on liquidity
Ten years on from the collapse of Lehman Brothers, financial authorities around the world have put in place a range of regulatory requirements that aim to ensure such an event cannot happen again.
While all such intentions are entirely laudable of course, there is a danger of creating negative and unwanted consequences. The prevention of some of the more esoteric investment bank practices may have the unintended (but largely inevitable) consequence of removing key market makers and thereby reducing liquidity and compromising the smooth operation of crucial markets. There are risks that more markets will be adversely impacted as regulations are introduced and as agents comply.