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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 November 2018 Forum we identified the following key themes:
The global economic expansion in the decade since the 2008/9 recession has at times been uneven and weak. But history shows that it is not unusual for recoveries that have followed financial crises to be laboured and stuttering or for them to require an extended period of policy support. That is certainly what it has felt like, although the hard data show a solid global expansion in 2010 and 2011 (the post-crisis rebound) followed by five years of more modest, but still quite reasonable growth by past standards (Figure 1).
Much of the relative weakness was concentrated in developed markets which, it could be argued, had felt the brunt of the global financial crisis (GFC) and were slower to recover. 2017 saw the strongest expansion since 2011 at almost four per cent and was characterised by a synchronised expansion across almost all countries. Growth in 2018 will be a little slower, but just as significant a change has been that there has been a greater divergence in the pace of increase across regions and nations. This theme is expected to continue in 2019.
The biggest change in 2018 has been the moderation of growth in Europe, especially noticeable after the boom of the previous year (Figure 2). Growth is not expected to return to that sort of pace, but neither is it projected to slow significantly further. Such a marked change in momentum is always going to be disquieting, but if it simply represents a return to a more sustainable pace of expansion, then it is probably to be welcomed.
Concerns that the modest slowdown in China might become more unruly, partly because of trade tensions, led the authorities there to introduce a range of stimulus measures to sustain growth. China will slow further in future years, but so far it has done so in an orderly manner.
Several emerging market nations have also seen growth downgrades for this year and next. This has been due to both idiosyncratic elements as well as the headwinds from the rising rates environment and stronger US dollar. US growth is still being helped by the fiscal boost, but that will fade in time, while the impact of tighter monetary policy will, as it is intended to, slow growth.
Overall, robust economic growth should continue in 2019 and 2020, but the global peak is (and several local ones are) now behind us. The next few years will see a gentle moderation in growth and greater divergences.
The Bank of America/Merrill Lynch (BAML) survey of Fund Managers for November continues to show that “Trade War” is the main worry for investors, as has been the case since March 2018.
The scale of such concerns has diminished slightly over the last six months, but that has often been the pattern with worries expressed in this survey – typically concerns fade over time, presumably as we become more used to the issue. Nevertheless, it is abundantly clear that trade tensions have already impacted financial markets, sentiment and activity this year and that there is every reason to expect them to continue to be an important theme over the next two or three years.
Both the IMF and the OECD estimate that the direct impact of tariffs imposed so far have had a negative, but small, effect on global growth – about 0.1 to 0.2 per cent, with a similarly-sized boost to global inflation over the next few years. However, they also highlight that the adverse effects could easily intensify, first because of the imposition of additional tariffs and assumed retaliation, as Trump has threatened. And secondly, as a result of further and more widespread escalation and negative feedback loops from financial market reactions and confidence effects. In these circumstances, the hit to global growth (from this alone) is estimated to reach almost one per cent, a major hit (Figure 3).
It is to be hoped that such escalation will be avoided. The focus at present is clearly on relationships between the US and China, with the Trump administration clearly determined to change China’s mode of operation permanently.
As we have said before, there are genuine grievances here, but tariffs are a blunt instrument that run the risk of unintended and adverse consequences. However, even if some meaningful deal between China and America were to be reached, it is very likely that trade frictions will form part of the macroeconomic and investment backdrop for many years to come, adding to uncertainties that are already impacting sentiment and growth (Figure 4).
Much of the last 50 years has been characterised by increased globalisation and greater openness. Those sands are now shifting and although most nations remain committed to free trade in some form, the tides of nationalism/populism that have grown stronger since the Global Financial Crisis are feeding a mood of greater self-interest in several geographies. While world growth has been on a rising trend, much of this sentiment has remained hidden in the background. But it is clearly there and could easily resurface in the event of a significant downturn in growth. Since global growth is expected to moderate, this theme is likely to remain relevant.
The next couple of years are almost certain to see tighter monetary policy in most countries, whether they be developed or emerging economies.
Financial markets have reined back their expectations of rate hikes a little in recent weeks, but it remains true that all central banks are expected to tighten policy, if only marginally in some cases, over the next twelve months. In the US the Federal Reserve (Fed) is actually almost three years into a tightening cycle, making this the second longest such cycle in the last 50 years. The average has been 15 months, highlighting just how unusual the present episode is.
After almost a decade in maximum stimulus mode and in a post-crisis environment, it is entirely sensible for central banks to take their time in withdrawing support. They can hardly be accused of rushing the job, although that has not stopped criticism of exactly that from some quarters. In the US this is comfortably the slowest hiking cycle in the post-war period. But at least they have started the slow journey back to some semblance of normality. The European Central Bank (ECB) and the Bank of Japan are still some distance away from rate hikes although both have reduced the scale of their unconventional monetary stimulus and have signalled their intention to do more (Figure 5).
Chair Powell’s latest messaging has re-ignited speculation that the Fed may be closer to the end of the hiking cycle than had previously been thought, with markets now pricing in the December 2018 increase, but only one more next year.
Our view is that the market may have slightly misinterpreted Fed thinking. We continue to believe, as does the Fed when judged by its infamous dot-plot, that 2019 will see additional rate hikes. However, we do accept there is scope for a pause in the one hike a quarter pace of tightening, because of worries about trade wars or the impact of lower oil prices on inflation, or some combination of those or other concerns.
Elsewhere, the ECB plans to raise European interest rates by September or October 2019, the Bank of England would like to hike but is hamstrung by Brexit uncertainty, while the Bank of Japan is inching even more slowly towards an eventual start to normalisation.
It should not be forgotten that real interest rates across the world are still very low by historical standards (Figure 6). But the key point is that macroeconomic conditions globally justify a tightening bias even if it is gradual and limited. That is a different investment backdrop to the one that has prevailed since 2008 and financial markets will need to take account of it.
Volatility has been rising across many financial assets as we transition from the ultra low levels reached in the second half of 2017, when the MSCI World Equity Index recorded its lowest 60-day realised volatility ever (Figure 7).
2018 has been a story of volatility returning to risk assets, but this has only occurred so far relative to an asset’s point on the risk spectrum, with Emerging Market equities exhibiting higher volatility than Developed Market equities and sovereign bond yields still recording historically subdued levels. Indeed, just last September yield volatility on USD 10yr swaps reached their lowest 60-day realised levels in nearly 40 years and 10yr EUR swaps their lowest since the formation of the single currency (Figure 8).
As we look into next year, there are reasons to believe that volatility will remain supportive for risk assets and also begin to rise for less risky assets. We anticipate that continued tightening by the Fed and ongoing Trade War issues will continue to provide emerging market volatility, while the inherent fragility of the US equity market will support domestic volatility as growth moderates into 2019. In addition, it is impossible to rule out the possibility that either Brexit or the Italian budget wrangling morphs into a major volatility event for European equity markets.
However, we also think it likely that rates volatility will begin to rise as we progress through 2019 as bond markets digest very different dynamics. The ECB is winding up its QE operations at the end of 2018 and will likely begin hiking rates next year, while we also expect the BoJ to add additional flexibility around its ‘Yield Curve Control’, which has hitherto involved direct market intervention to suppress the volatility around 10yr JGBs. Combined with the increased issuance required by the Fed to fund Trump’s last round of tax cuts, the demand/ supply dynamic for global sovereign debt will likely be far less investor friendly next year. Furthermore, despite continuing forward guidance from the Fed, an expected moderation in US growth next year will likely increase uncertainty around the path of policy rates sufficiently to also lift US rates volatility. If this is combined with a steepening curve, this could also transmit to longer-dated yields, which have been particularly subdued in 2018.
This therefore adds up to a rising tide of background volatility across most asset prices compared to levels we have recently become accustomed to as we head into 2019. Assuming global growth remains sufficiently solid however, this should remain reasonably contained.
Fears in some quarters that ultra-loose monetary policy in the wake of the crisis would lead to runaway inflation have proved misplaced. They also betrayed a fundamental misunderstanding of how inflation is generated. But now that the US economy is effectively operating back at full capacity (demand equals or perhaps even exceeds supply), there is more of a chance that inflation will make a comeback. So far, it has been a clear but understated reappearance (Figure 9) but there is a risk that buoyant demand, boosted additionally by unnecessary fiscal stimulus, could lead to a more disorderly outbreak of inflation as the US overheats. The Fed would have to pick up the pace of tightening and that would be a major change for financial markets.
It was five years between Draghi’s “whatever it takes” speech and the peak of the recent euro zone boom in the middle of last year. The euro zone sovereign debt crisis and the Greece calamity were fading, politics seemed to be stabilising and the coordinated upswing led to a growing belief that the single currency are could join in the growth party.
The last year has seen growth disappointments for the region overall and some resurgence of the populist and nationalist mood, most notably in Italy where the very odd coalition government has chosen to pick a fight with the European Commission about budgetary discipline. Although this is a far cry from an existential threat to the single currency region (as Greece was), if one were to emerge, this might be how it starts. Euro zone frailties could yet be exposed in the next downturn, whenever it comes.
China is now a pivotal player on the world stage (Figure 10). What happens there matters fundamentally to the global macroeconomy.
The US, led by Trump, has chosen to confront China head on in the trade arena, but the conflict is really a reflection of wider unease regarding China’s current and future role in a global context. It may be that bilateral trade tensions are defused, but there is a risk that dogmatic approaches and entrenched positions on both sides may lead to an impasse that effectively isolates China. Such an outcome could accelerate the de-globalisation tide that has already developed in recent years and lead to an almost “Cold War” state of affairs between China and “the rest”. While it is difficult to define how exactly this would look, it does not look constructive for world growth and global integration prospects.
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, the extended period of super-low borrowing costs that followed will have encouraged some companies and households to take on excessive debts (Figure 11).
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.
10 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, 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 compromising the smooth operation of crucial markets (Figure 12). There are risks that more markets will be adversely impacted as regulations are introduced and as agents comply.
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