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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 September 2018 Forum we identified the following key themes:
It is generally accepted that the current global expansion began around the spring of 2009. It is therefore almost a decade old, making it one of the longest post-war upturns. Aggregating world GDP is not simple, but using US data is a reasonable benchmark as cycles are generally closely aligned.
The average length of US upswing since 1945 has been 5½ years, but if the “stop-go” episodes (pre-1980) are excluded, it is more like 8½ years (Figure 1). Such comparisons have persuaded several commentators to characterise the present situation as “late-cycle”.
While this is selfevidently true on the basis of time elapsed, in our view it is not an especially helpful or useful description. In the past there was usually a very close correspondence between movements in interest rates and the business cycle. But the recent experience has been unique and has included an extended period of ultra-loose monetary policy that has never been seen before. This time really has been different.
Partly as a result, there is no reason that the robust global growth that we have witnessed in recent years cannot continue for some time yet.
We expect global GDP to rise by close to 4 per cent in both 2018 and 2019, similar to projections made by the IMF in July (Figure 2). This comprises growth in the developed world of around 2¼ per cent and in the emerging nations of close to 5 per cent. Alongside the return of sustained positive inflation (see below), this has required Central Banks (CBs) to move interest rates higher or signal their intention to do so. But they are tightening policy very slowly, allowing the cycle to be extended.
The global expansion is still widespread, but has recently become incrementally less synchronised, with the US accelerating, while Europe and Japan have slowed slightly. Growth has also become less even in some emerging and developing economies. These developments need watching, but for now the theme of ongoing growth is the dominant one.
One of the fears in the aftermath of the Global Financial Crisis (GFC) was that very low (even negative) interest rates and the poorly understood “printing of money” implied by Quantitative Easing (QE) would lead inevitably to runaway inflation. It didn’t happen. Rather, deflation became a far greater threat, especially in some geographies.
Central Banks’ extreme actions represented a bold attempt to ward off that risk. Memories of the Great Depression warned them that if deflation took root, it would cause great economic pain and could be hard to shift. Far better to take supposed upside risks with inflation which, it might be argued, they knew how to deal with. In fact, conditions of excess supply meant that inflation remained quiescent in most places (some in particular) for much longer than expected. But as demand has recovered it is now making a belated comeback.
This trend is unsurprisingly most advanced in the US where the economic recovery is most advanced. There, the additional boost provided by Trump’s fiscal stimulus is ensuring well above-trend growth at a time when the economy is operating close to full capacity.
The result is ongoing, but as yet modest, inflationary pressures in product and labour markets. But inflation has returned elsewhere too. Although there is an energy price element to the latest increases around the world, inflation rates in most developed markets are now at or above target, typically around 2 per cent (Figures 3 and 4).
These developments have helped cement in agents’ minds the notion that inflation is back and here to stay, a conclusion that can become self-fulfilling. There are still some places where inflation has returned less convincingly, but generally this has been where the recovery post-GFC has been weaker. If above-trend growth continues, as looks likely, inflation will move higher in time. It may well be the case that in today’s interconnected, tech-heavy world, inflationary outbreaks like those seen in the past are much less likely. But a low, positive inflation environment looks the most probable backdrop over our investment horizon.
There is no doubt that trade tensions have become markedly worse in the last three months (Figure 5). They have been focussed on US-China relationships, underpinned by Trump’s determination to change the way that China operates. While there are genuine grievances here, tariffs are a blunt instrument. Moreover, the US is not the only superpower – China is unlikely to simply roll over and give in to US demands and has plenty of clout of its own.
It is important to distinguish between the bilateral spat concerning China and the US – of course it can be described as a trade war between them, but that is not the same as a global trade war. That is not to say that one cannot yet develop. After all, Trump’s language and record on diplomacy and common sense can cause and have caused flare ups in many different arenas (see the Risks section).
The immediate effects of tariffs and the trade dispute are not immaterial, but neither are they a macro-economic game-changer as yet. On the basis of the measures so far announced, we estimate that global growth may be lower by perhaps 0.25 percentage points and inflation higher by a similar amount. But there is always the risk of further escalation – indeed Trump has already highlighted possible areas of future conflict such as an extension of tariffs to areas that could impact more widely – for example auto tariffs (Europe and Japan).
There is also the very real danger of negative feedback loops: the toxic environment created by tariffs has already affected financial markets significantly in 2018. If business sentiment falls as a result, real economic variables – investment and employment for example – could be next. Finally, it should not be forgotten that Trump can move from aggression and bluster to self-proclaimed deal successes very quickly.
Over the next few years we expect most Central Banks around the world to continue to follow the lead of the Fed and slowly end the period of exceptionally loose monetary policy. “Unconventional” policies (QE and the like) have already been wound down or stopped in several nations and others are using “forward guidance” to indicate that they will not be there for ever. However, this hiking cycle – if it can be called that – will be rather different from those in the past. To borrow the Bank of England’s language, rate rises are going to be “at a gradual pace and to a limited extent”.
Nevertheless, an era of gently rising interest rates is set to characterise the investment backdrop over the next two or three years and that is a very different environment to the one that has prevailed on and off since 2008 (Figure 6).
The caution shown by Central Banks in withdrawing stimulus is justified and understandable. The legacy of the GFC is still visible in many areas, but they are right to be trying to normalise policy, even if it is to a new normal.
We expect the Fed to raise US rates once more this year and three more times in 2019 which will take them back towards neutral, although there is a lively debate as to where that is, both across and within countries. Estimates of the neutral rate vary greatly. The neutral rate has probably fallen in recent years, but the actual rate is still some way below it (Figure 7).
The ECB plans to stop asset purchases by the end of this year, but is not expected to raise rates until the autumn of next year. The Bank of England has hiked twice and intimated that further increases will come. All is dependent on a smooth Brexit process which is not certain. Normalisation in Japan may take longer, but an upward bias over the medium-term is still likely.
While last year saw a collapse in equity volatility to historically very depressed levels, recent weeks have seen volatility across core rates markets fall to multi-decade lows. US 10-year yields, for example, have recently recorded their lowest three-month realised volatility since 1979 (Figure 8).
Periods of low asset price volatility are common during times of economic expansion and 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, different asset classes are following a typical pattern of bottoming or gently rising volatility as the economic cycle matures.
In core asset markets we therefore expect that ultra-low levels of equity volatility reached last year are unlikely to be retested and that volatility of other assets will either bottom or continue to grind higher. This is a natural process over time and one that might occur even if the cycle were to show no sign of slowing.
The US is further through its economic cycle than other global economies and the tightening in policy rates that is appropriate to it will also 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 of currency and rates volatility. Such pressures will likely underpin asset volatility in these markets, while Trade War risks also have the potential to keep volatility elevated in some regions, particularly if such risks begin to impact growth.
The risk of a more damaging trade war has intensified as Trump belligerence has grown. Some of his antagonism is related to the US mid-term elections in November (tariffs poll quite well across the political spectrum) and therefore could possibly fade in time. But part may be a more fundamental and worrying element of the Trump doctrine. The US has paid lip service to re-establishing a level global playing field in terms of international relations (including trade).
However, Trump’s actual agenda might be far more insular and parochial. His true ambition could be to reassert the US’s position as global economic and political powerhouse, whatever the cost. Populism and inward-looking nationalism have not been confined to the US in recent years, but this development would be a much more significant one (Figure 9).
During the 2015/16 scare, China slowdown was the single most important worry for investors. There has been an extended period of calm since then despite the intensification of trade tensions and a 30% drop in China’s equity markets. But upside growth surprises are unlikely to continue: a secular slowdown in China is inescapable in coming years (Figure 10).
The key is how it is managed and whether investors have accepted that it is an inevitability and need not be feared. No country has been through the transition from emerging to developed economy without bumps along the way. China’s policy-makers 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.
Many commentators believe that inflation is “yesterday’s problem”. In comparison with the inflationary 1970s and 1980s, this may be true thanks to the institutional frameworks in place and the more open global economy (Figure 11).
After the experience of the GFC, most central banks seem willing to trade off the danger of inflation moving above target against that of growth stalling or slowing disturbingly. The risk is that rising inflation becomes entrenched while growth stays solid, obligating rate-setters to hike more aggressively. This is most likely in the US where inflation is already very close to target (and rising), but where financial conditions are still historically loose. An environment where the Fed is trying actively to slow growth would be a major change for markets.
Periods of rising interest rates reveal where debts taken on when rates were low have become most onerous. Although there was significant “de-leveraging” in key areas during and after the GFC (Figure 12), the extended period of super-low borrowing costs that followed will have encouraged some companies and households to take on excessive debts. It is only when rates rise that such vulnerabilities are exposed and that is the regime that we are now entering.
The main areas of obvious concern are those that we identified three months ago: some US corporates, emerging markets that rely on US dollar funding, peripheral G10 property markets and the most indebted Governments. But these episodes always throw up surprises.
Ten years on from the collapse of Lehman Brothers, financial authorities around the world have put in place a swathe 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 unwarranted 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 of 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.
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