Why it’s too early to retreat from risk
Although confronted with a maturing growth cycle and the likelihood of more modest returns, the catalysts typically leading to past downturns appear largely absent - such as sharply tighter monetary or fiscal policy and financial crises. Notwithstanding our sense that 2018 is a year to stay positive, we have highlighted five macro and market signals we need to keep seeing in order for us to stay engaged with risk, ahead of potentially moving to a more defensive stance on markets.
The business cycle is maturing, not ending
Recessions and economic downturns are notoriously hard to forecast, and this uncertainty is why we focus so heavily on maintaining appropriately diversified portfolios. That said, as this current economic recovery has been very prolonged, especially in the US, it is not surprising that there is so much focus on when this cycle will end.
“Consensus is not always good; disagreement not always bad. If you do happen to agree, don’t take that agreement—in itself—as proof that you are right. Never stop doubting...” – Philip Tetlock (Superforecasting, 2015)
Our view is that the current momentum in leading indicators of growth across the global economy, including improving jobs markets and positive signs for future business investment, align more closely with a maturing or slowing growth cycle, rather than one that is on the cusp of turning negative. Indeed, business investment, given high company profitability, should become a more noticeable driver of growth through 2018 (and could limit future inflation).
With inflation continuing to drift only moderately higher, and central banks lifting rates gradually in response to better growth (not above-target inflation), this post-boom phase of the growth cycle should deliver outperformance of equity returns relative to bonds, even if those returns are more moderate than in 2017. Indeed, historically, unless we are within six months of an economic downturn, global equities have typically continued to deliver double-digit returns during periods of strong economic growth.
Expansions don’t die of old age
This has been a long global economic recovery, and one of the longest on record for the US. But as research by Glenn Rudebusch of the Federal Reserve Bank of San Francisco showed a couple of years ago, “a long recovery appears no more likely to end than a short one”.
Prior to World War II, the longer a business cycle, the higher the probability that it would soon come to an end. However, since World War II, cycles have not shown this tendency. This may reflect the rising share of more stable service sectors in economies, more stable governments, as well as the focus of policy makers on macroeconomic stability. Indeed, at a 2015 Federal Open Market Committee (FOMC) press conference, Chair Janet Yellen noted:
“I think it is a myth that expansions die of old age. I do not think they die of old age. So, the fact that this has been quite a long expansion doesn’t lead me to believe…its days are numbered.”
Recoveries typically end because something goes wrong! The key risks on our horizon can be broadly categorised into either higher-than-expected global inflation, or something that causes global demand to slump, such as trade wars or other geo-political events. Financial crises should also be considered a risk, with China a possible catalyst as it increasingly focuses on deleveraging its economy.
None of these imbalances seem imminent. As the cycle matures, our focus must be on ascertaining early enough when and if these risks are more likely, as this will materially impact investment returns in the period ahead. As the market focuses on the same, this will likely lead to heightened volatility.
Valuations aren’t extreme, but caution is warranted
According to UBS Global Research (UBS), equity market valuations are above average, but still not overly expensive, particularly outside the US. Nor are equities expensive relative to bonds. While equity markets may have run ahead over the past couple of quarters, there is a strong likelihood that momentum in the global earnings cycle is converted into capital gains for shares as 2018 unfolds. This is despite multiples in relatively more expensive markets likely being capped around their current elevated levels.
While we expect government bond yields to drift higher, they should remain anchored by relatively low inflation and still low central bank rates—many structural disinflationary forces also remain in play. Of course, an ongoing rise in bond yields will create a challenge for bond-sensitive equity sectors.
Five signals to watch
Notwithstanding our sense that 2018 is a year to stay positive, we highlight five signals we’ll be monitoring throughout the year. Together, their demise should provide an early warning that a more risk-off environment is unfolding.
1. Inflation stays benign in the major economies
As UBS Global Chief Economist, Arend Kapteyn, noted in his 2018 outlook,
“inflation is not dead, just sleeping”.
There are stirrings of price and wage pressures across the world, and the number of countries experiencing a drift up in core inflation is at its highest since 2011. But the process is slow, and with inflation still below many country’s inflation targets, central banks are expected to proceed with caution. 2018 will likely be characterised by only a very gradual normalisation of interest rates.
But there remains the risk of an unanticipated inflation shock given the current momentum in global growth. Maybe there is less spare capacity in jobs markets than we think? Geo-political events that impact the price of oil and other commodities could be another catalyst. The negative implication of an inflation shock for almost all asset classes suggests this is a key risk.
Targets to monitor— the US Federal Reserve’s preferred core (PCE) inflation measure is currently 1.5% year-on-year. This needs to stay below the FOMC’s end-2018 target of approximately 2%. Europe’s headline inflation, currently 1.4%, needs to stay below the European Central Bank’s (ECB) target of 2%.
2. Wage growth remains contained
Real wage growth is one of the key leading indicators of inflation pressures, often flagging stronger consumer demand ahead. A sharp broad-based pick-up in real wage growth may lead central banks to tighten policy more quickly.
Target to monitor—US average hourly earnings have risen to 2.5% and need to stay below 3.5% to avoid market concern that the inflation outlook is no longer relatively benign.
3. Slowing global growth…but not too slow
It seems unlikely that global growth data—or at least leading indicators of confidence and production, often called ‘soft’ data—can continue to surprise as positively over the coming year as they did in 2017. However, as the growth cycle matures, an easing-back in some of these soft data does not necessarily mean falling company earnings ‘growth’.
Indeed, history shows that the global purchasing managers index (PMI), could pull back from its current high level and still be consistent with positive (though more moderate) equity market performance. The PMI is currently at a near-decade high of around 55, with above 50 signalling growth.
Target to monitor—the global PMI needs to stay above a level of around 52 to be consistent with rising equity prices.
4. Earnings continue to rise—even if growth moderates
It’s one thing to highlight robust synchronised economic growth—but unless this translates into rising company earnings, that strong growth may not support higher equity prices.
Targets to monitor— earnings growth can slow across regions, but it will need to stay positive—that is, earnings will need to rise in an absolute sense.
5. China credit growth remains in double-digit territory
Efforts by China’s regulators to prioritise deleveraging, while maintaining good growth, are not without risk or global implications. China’s global dominance in production and commodity demand means that any signs that regulators have tightened too much (such as a sharp slow-down in property or infrastructure investment) could be a significant headwind for sentiment.
Target to monitor—China’s total credit growth, which has slowed from 16% to 13%, needs to continue to grow at a double-digit pace.
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Scott has more than 20 years’ experience in global financial markets and investment banking, providing extensive economics research and investment strategy across equity and fixed income markets.