We are late-cycle optimists. With US equity indices at record highs and 10-year US Treasury yields only modestly off their all-time lows, we expect investors will be focused on downside risks as they enter 2018. We have a lot of sympathy for such concerns, but we see little risk that the number one catalyst for a market correction – namely recession – is likely to materialize in 2018. While, chronologically, we are late in the business cycle, we see good reason to think this expansion can extend for longer.
It usually pays to worry about recession risk during ‘late-cycle hiking cycles’. When central banks are hiking rates to combat late-cycle inflationary pressures, recessions often happen. But this time may be different. In particular, given the weakness of inflation and anchoring of inflation expectations in most developed economies, policy makers today have less clear motives to tighten monetary policy as aggressively or pre-emptively. Indeed, we expect the tightening of monetary policy to continue at a gradual pace by historical standards. This bodes well for the length of the current expansion.
Caution is nonetheless warranted. Market corrections do not require recessions, and we see other reasons to think correction risk is elevated. First, we worry that a continued rally in equities from here is heavily levered to higher earnings. While our colleagues in equity strategy expect continued growth in earnings-per-share, there are good macro reasons to think the risks to this view are skewed to the downside. With the labor market heating up, inflation in check, and productivity growth low, the trends are headed in the wrong direction for corporate profit margins (“What Happens to Profits if Wages Catch up with Productivity?” Global Markets Daily, May 23, 2017). Second, while we do not expect the Fed’s ‘quantitative tightening’ to have a major impact on bond yields, it may nonetheless pose problems for market psychology. Clients invariably rank QE high on the list of reasons for inflated asset market valuations. Since what matters for market valuation is what investors think, we worry that the removal of QE poses a non-trivial risk to market sentiment.
Since corrections without recession tend to be short-lived, we think the wisdom of ‘buy the dip’ will persist into 2018. We recognize that such simple rules are naive, and we further recognize that this strategy has already had a long run. But if recession is avoided in 2018, we see a compelling reason to think this simple rule of thumb should continue to perform. We recommend erring on the side of remaining long risk rather than trying to time the next equity downturn (“Bear Necessities”, Portfolio Strategy Research, Oct. 4, 2017).
Despite our conviction on growth stability, we also worry that risk premia have fallen to record-low levels in both bonds and equities. In bond markets, our estimates of term premia are actually negative, but we expect these premia will gradually normalize as the cycle ages and inflation rises (“Low Term Premium: Why We Should Care”, Global Markets Daily, Nov. 8, 2017). This suggests remaining underweight or short bond duration. In equity markets, our estimates of risk premia are low but still positive (“Bonds vs. Equity: Fixing the Fed Model”, Global Markets Analyst, Jun. 16, 2017). We therefore remain overweight on a relative basis in our asset allocation views, while acknowledging that absolute returns will likely be lower (“Goldilocks still escaping the bears,” GOAL: Global Opportunity Asset Locator, Sept. 19, 2017).
Our recommended Top Trades for 2018 reflect many of these themes (Global Viewpoint,November 16, 2017). In equities, for example, we think the compressed level of risk premia means that price appreciation is more likely to come from earnings growth than from multiple expansion. We therefore recommend EM equity exposure, since emerging economies have more room to grow. We also like select FX exposures in EM, including countries with global growth betas via commodities (such as Chile and Peru).In credit, we think stronger US growth has helped pushed credit premia tighter in US High Yield than in EM credit, whereas the US now seems poised to slow while we think EM growth still has room. We therefore recommend being long EM credit vs US High Yield. In rates, we recommend being short 10-year US Treasuries to capture the view that the forwards under-estimate the pace of Fed policy hikes, and to crystallize a progressive normalization of the bond term premium. And in G10 FX, we recommend going long EUR/JPY to position for a continued rotation around a ‘soggy’ Dollar (that is,a Dollar that has all but finished pricing the relative strength of the US vs. the global economy).
1. Global Growth: Stable and Synchronized
Following years of global economic growth disappointing to the downside, 2017 is shaping up to be the first year of the expansion in which growth surprises to the upside. We expect 2018 to deliver more of the same. We forecast global growth of roughly 4% in real terms for both 2017 and 2018, suggesting that next year’s global economy will likely also surprise on the upside of consensus expectations (“As Good As It Gets”Global Economic Analyst, Nov. 15, 2017). In asset markets this growth should continue to support pro-cyclical assets while pushing inflation and bond yields gradually higher. A nuanced risk to this view is the modest sequential growth deceleration that we forecast for developed market economies (DMs), which reflects the fact that most DMs are currently growing well above potential. While the slight slowdown in DM growth may present a near-term headwind to market sentiment, we think the offsetting strength of EM growth should support a broadly ‘pro-growth’ pattern across asset markets in 2018.
The continued strength of the current expansion owes to several forces. For one,growth momentum remains strong, a fact which bodes well statistically for the year ahead. Second, global financial conditions − as measured by our battery of GS FCIs −have continued to ease over the past year. Our estimates suggest that the growth impulse from this easing will peak at year-end for DM and in mid-2018 for EM (Exhibit 2).Third, while we expect the slow tightening of monetary policy to continue in the US,global monetary policy remains highly accommodative by historical standards. Finally,US fiscal stimulus now seems more likely than not and, whatever its outcome,diminished fiscal restraint remains a broader theme for the year ahead. All of these factors contribute to our relatively optimistic growth outlook for 2018.
The downside risks to growth may be lower than the chronological age of the US expansion suggests. For one, the global expansion is not as old as the US expansion. In addition, expansions often end as a result of unsustainable economic imbalances, but in the US it is currently hard to identify such imbalances. Borrowing by households and governments, for example, has been relatively restrained. Corporate borrowing has been more aggressive, but companies have been able to lock in low financing rates at long maturities. The US is still running a significant current account deficit with the rest of the world, but at just -2.7% of GDP it is less than half as deep as its pre-crisis lows and has been stable for the past several years. The sector of the economy that arguably looks most stretched is the labor market, but even here, judging by wage inflation, the imbalances are still mild.
2. DM Monetary Policy: No Motive for Murder
It generally pays to worry about recession risk when central banks are hiking rates late in an expansion. But we see reason to think this expansion can live well into old age.Over the past 50 years, inflation expectations have likely never been as well-anchored as they are today. This diminishes the need for central banks to “pre-emptively” respond to inflationary pressures. As a result, the risk of over-tightening and prematurely ending the expansion should be correspondingly lower. As the famous MIT economist Rudi Dornbusch liked to say, none of the post-war US expansions died of natural causes, they were ‘murdered’ by the Fed while attempting to fight inflation.Policy makers today have no clear ‘motive for murder’. Inflation rates in most developed economies are low and expectations well-anchored. This anchoring was particularly visible during the global financial crisis, when inflation expectations remained surprisingly high despite the severity of the downturn. And since then, inflation rates have remained low despite the recent robustness of the recovery. Although idiosyncratic factors can explain some of the recent inflation weakness, the experience of the past few decades suggests that the implementation of central bank policy has simply gotten better. Inflation targeting has been a major institutional innovation that has helped to establish central bank credibility on long-run inflation targets. For this reason, this time may indeed be different. In past hiking cycles, markets were skeptical about central banks’ willingness and ability to fight high inflation. This forced policymakers to err on the side of over-hiking in order to establish their anti-inflation credibility. In the current cycle, by contrast, markets are more focused on the risk of deflation. Thus, central banks are instead erring on the side of “caution” and “patience” to establish their deflation-fighting credibility.As a result, the risk of ‘involuntary manslaughter’ of the business cycle is likely low. This suggests that the current US expansion (and possibly the current bull market) may live longer than the 4.1% unemployment rate would suggest. While the Fed has obviously begun hiking, the pace of these hikes has been far more dovish and “patient” than past hiking cycles. The last time unemployment was this low (in October 1999), the Fed funds rate was at 5.25% and the Fed was on its way to adding another 125bp of hikes over the following year, pausing only when the rate reached 6.5%. Today, by contrast, the Fed funds rate is just 1.25%, which is still considerably below where most Taylor-Rule implementations would put it, even with rules that assume the natural real rate of interest (R*) equal to 0 (Exhibit 3). While our economists’ forecast envisions nine more quarter-point hikes by the end of 2019 – considerably more than the market is expecting − this would still go down as one of the most dovish hiking cycles of the post-war period.
3. Drawdown Risk: Bear-Market Warning Signs
Low recession risk does not necessarily imply low drawdown risk. The S&P 500 is currently in the fifth-longest streak without a 5% correction since 1929, which naturally raises the question “How high is drawdown risk?” Markets have been comfortably settled into a low-volatility regime since mid-2016, but many preconditions for a bear market are falling into place (valuation, ISM growth momentum, unemployment, inflation and the slope of the yield curve). Our equity strategy teams’ bear market risk indicator now signals a 68% chance of entering a bear market over the next 12 months (Exhibit 4) (Bear Necessities; identifying signals for the next bear market,” Global Strategy Paper, Sept. 13, 2017).
But it’s not all bad news. Not only does well-anchored inflation mitigate the risk monetary policy poses to this bull market, we see little evidence today of the kind of imbalances that preceded the global financial crisis (GFC), reducing the risks of a structural bear market (“Reluctant Bulls”, Global Markets Daily, Nov. 2, 2017). Moreover,2017 was a year of unusually low volatility and, somewhat surprisingly, history suggests this actually reduces drawdown risk. Low-volatility regimes are persistent. The average low-vol regime since 1928 lasts 22 months, and since the 1990s, it not uncommon to see low-vol regimes last three years or longer (“The upside of boring - risks and asset allocation in low volatility regimes,” GOAL - Global Strategy Paper, Jun. 21, 2017).
While low volatility may not be a problem, high valuations are. The elevated levels of current valuations raise drawdown risk for the simple reason that there is less of a cushion to absorb shocks, whatever their origin (Equity Drawdown Risk – Is the Trend Still Your Friend?, GOAL: Global Opportunity Asset Locator, Mar. 14, 2017). Two key risks to this bull market stand out. First, rising wage inflation with stagnant price inflation and sluggish productivity growth will continue to put pressure on US profit margins. Second, while we do not expect ‘quantitative tightening’ (QT) to have a major impact on bond yields, markets may nonetheless believe that global QE has been an important driver of the rally. Hence, its impending removal may pose a psychological risk to investor sentiment. That said, corrections without recessions more often bounce. The better the macro backdrop remains, the less likely it is that the next drawdown will signal the start of the next bear market.
4. Emerging Markets: More Room for Growth
While we are confident that activity will remain strong in developed markets next year,we are particularly optimistic about growth in emerging economies. Since most DM economies are currently growing well above their potential rates of growth, without a pick-up in productivity growth (which seems hopeful at best), DM growth looks likely to moderate. However, emerging markets have more room for growth in 2018 (Exhibit 5).
Both the domestic and external environments point to EM outperformance. First, the domestic foundation for growth in EM is strong. EM macroeconomic fundamentals have vastly improved since the ‘taper tantrum’, creating a macro backdrop conducive to resilient and sustained growth: current account deficits have decreased, inflation has moved towards targets, and the pace of debt accumulation has ticked down outside of China. Second, the external environment for EM has vastly improved. In particular, after five years of post-crisis stagnation, and a common narrative that we had reached “the end of globalization”, strong growth in global trade – and, with it, strong performance of the trade-sensitive assets of EM – has returned (“The (tr)end of globalization“, Emerging Markets Analyst, May 12, 2017).
On top of these solid internal and external developments, we have begun to see signs that it is still early innings in the EM recovery. After years of drag, the impulse from EM financial conditions has finally turned positive. FDI inflows, which had slowly deteriorated after the GFC, have stabilized (“FDI Flows into EM: Still Lagging, But Showing Signs of a Pick-up“, Global Markets Daily, Aug. 11, 2017). Finally, the cross-country synchronicity of EM growth today rivals that seen during the 2000s – an extended period of strong EM growth (“EM growth: Synchronicity Should Fuel Longevity“, Global Markets Daily, Aug. 18, 2017). In our view, these trends can continue and are constructive for EM equities, credit and FX.
5. China: A Well-Managed Slowdown
While we and consensus expect a China slowdown this year (we forecast that real GDP growth will slow to 6.5% in 2018 from 6.8% in 2017), we do not see much risk of repeating the ‘global growth scare’ that was precipitated in part by China’s growth slowdown in 2015. We think the slowdown will be policy-led and carefully managed, which should reduce the risk of a negative shock to Chinese assets, commodity prices, or global growth concerns more generally.Efforts to curb excess financial leverage, industrial overcapacity, and pollution all come with risk. There is clear emphasis following the Party Congress that policies will focus on growth sustainability, reduction of inequality, and risk control relative to top-line growth. With several new economic policy makers taking office in the coming months and with the overhang from the leverage growth over the past decade, there is considerable scope for uncertainties in policy calibration. As the market sell-off in late 2015 demonstrated, a minor tremor owing to Chinese policy can have global ramifications. That said, it is our judgment that Chinese policymakers are learning to calibrate policy more carefully. When it comes to financial-sector risks, for example, 2017 showed that officials can target the growth of shadow banking while mitigating the headwinds to growth (Exhibit 6) (“Nimble on the Brake as Credit Headwinds Gather”,Asia Economics Analyst, May 21, 2017).
A well-managed slowdown in China should provide a broad degree of comfort to asset markets. We continue to like local equities, which should benefit from solid earnings growth and reasonable valuations (“After (Congress) Party?”, Asia Portfolio Strategy, Oct.25, 2017). On the credit side, the careful approach to policy changes and SOE reforms suggests that default risk will be idiosyncratic rather than systemic (“Identifying ‘Zombie’ Companies in China; An Update on Recent China Onshore Bond Defaults”, Asia Credit Trader, Nov. 10, 2017). In FX, we see little reason to expect a 2015/2016-style disruption. Officials have successfully stabilized the reserve drain and the depreciation we expect next year – much like the growth slowdown itself – should happen at a measured pace (“China’s Big Reshuffle”, Top of Mind, Oct. 12, 2017). For the rest of EM,China’s growth reinforces our expectation of continued strength in global trade, which
should help the emerging market recovery (“Global Trade is Heating up Open Economies”, Global Markets Analyst, Sept. 27, 2017). Finally, stable growth in China alongside strong global growth supports the case for commodities, which should favor commodity-related EM equities and currencies in the year ahead.
6. Global FX: Soggy Dollar
With the US unemployment rate continuing to fall and wage growth picking up, the Federal Reserve looks poised to continue raising interest rates in 2018: our US Economics team expects four hikes next year. But rate hikes need not translate automatically into Dollar appreciation in the context of healthy global growth. During the last tightening cycle from mid-2004 through mid-2006, for example, the FOMC hiked at 17 consecutive meetings, taking the Fed Funds rate from 1% to 5¼%. Over this same period, the trade-weighted Dollar fell by about 7%, weakening against both G10 and EM currencies (Exhibit 7). In hindsight, we can see that favorable developments outside the US likely resulted in the appreciation of other currencies — improving terms of trade from higher commodity prices, falling risk premia, and risk asset outperformance. While there are important differences, this period may be a good template for USD performance in the current market environment.
The main beneficiaries from a relatively soft USD should be EM exchange rates. A number of EM currencies have struggled in recent weeks alongside higher core yields and, in some cases, renewed political risks (“The Return of Idiosyncratic Risk”, Global FX Views, Nov. 7, 2017). However, the fundamental case for EM FX remains solid. Most EMs have significantly improved external balances and cyclical fundamentals. Plus, the asset class offers undemanding valuations, a generous level of real carry and exposure to global growth. We forecast total returns for the major/liquid EMs of 7% over the next 12 months, with the best risk-adjusted returns in INR and IDR, and the best total returns in ZAR and TRY given the high levels of carry. For the latter, unlocking this return potential will likely require some resolution, or at least de-escalation, in political risks. The best middle ground may be BRL: the currency has underperformed on fiscal developments, but Brazil’s macro fundamentals are clearly better.
Within developed markets, we think domestic and global factors favor EUR relative to JPY, and we forecast that the cross will approach its cyclical highs in 2018. The Euro appears undervalued and under-owned. Given above-trend growth and reduced political risks, investors will likely continue returning to Euro area assets. In contrast, the Bank of Japan’s Yield Curve Control policy should keep the Yen closely correlated with global bond yields. In the UK, despite the Bank of England’s recent hike, the combination of Brexit deadlines and fragile politics points to downside risks for the Pound. The remaining G10 markets should see central bank action in fits and starts – investors will need to keep a close eye on inflation data and policy maker communication.
7. US Policy Risks: If It Rains It May Pour
Heading into 2018, one of the top policy risks in focus for investors is the passage of US tax reform. A second policy risk which has fallen off of radar screens, but which is still active, in our opinion, is US trade policy. The two risks are potentially linked. If tax legislation fails to pass, it would be the second major legislative failure during President Trump’s first year in office. Presidential approval ratings would likely fall, and the Trump administration would be under renewed pressure to ‘get something done’ in advance of the mid-term elections. Under this scenario, we see a risk that the ‘something’ would be a more assertive stance on trade and foreign policy.The temptations of ‘diversionary foreign policy’, as political scientists call it, are age-old; “Be it thy course to busy giddy minds / with foreign quarrels,” wrote William Shakespeare in Henry IV. In the case of the Trump administration, the concern coming into 2017 was that the administration’s “America first” trade views could lead to breakdowns in global trade. We felt such concerns were overdone, mainly because we thought that the repeal of NAFTA, for example, would be too detrimental to the administration’s ‘pro-growth’ agenda. We nonetheless acknowledged the risk of trade tensions, especially vis-à-vis China, since China runs by far the largest net trade surplus with the US. In practice, however, aggressive trade negotiations with China appear to have a taken a backseat to the desire for cooperation on North Korea. This may help explain why President Trump’s calls for ‘fair trade’ have been focused around NAFTA and the potential for a US withdrawal in recent months (“Thoughts on the Potential US Withdrawal from NAFTA”, US Daily, Oct. 19, 2017). While withdrawing from NAFTA would likely have only modest economic consequences for the US and Canada, it would have serious repercussions for the Mexican currency, and would add to the negative headwinds more broadly if it were to follow a failure on tax reform. On the other hand, if tax reform succeeds, then the administration would be in a better political position to make the compromises necessary to successfully renegotiate NAFTA. While such a renegotiation would likely take years, the economies of the US, Canada and Mexico would likely benefit from the expected success (especially in NAFTA-exposed sectors, such as autos). We currently see an 80% chance that tax legislation becomes law in early 2018 (“Tax Reform: Raising Our Expectations”,US Daily, Nov. 14, 2017). As goes tax reform, so may go NAFTA.
8. Bond Term Premia: Gradual Normalization
The term premium in government bonds – the additional compensation that investors require for bearing duration risk in longer-dated fixed income securities – is historically low and even negative in some of the major markets. Part of the decline in the premium is most likely a reflection of the macro environment, characterized by a prolonged expansion creating a lot of jobs, but comparatively little inflation. But the extremely low level the premium has reached probably stems from the actions of central banks. The introduction of negative rates and the launch of large-scale purchases of long-dated bonds appear to have played a growing role in depressing global bond yields, especially since 2014, leading long-term investors to embark on a ‘search for yield’ across the globe (“Macro Drivers of the Bond Term Premium”, Global Markets Analyst, Aug. 4,2017).
2018 looks ripe for a rebuild in the term premium. With the expansion deepening and broadening, wage and commodity cost pressures emerging, and financial conditions remaining easy, the major central banks have progressively appeared less keen to subsidize duration risk on such a large scale. The Fed has already announced that it intends to roll over a smaller amount of the government bonds maturing on its $2.5 trillion holdings. Similarly, the ECB will gradually bring net purchases of Euro area securities to an end over the course of next year. Combined, these policy shifts will start reversing the compression of term premium in recent years. While central banks will proceed with caution when unwinding QE since memories of the ‘taper tantrum’ are still fresh, the shift to QT is happening, predictably, at a time when inflation and inflation uncertainty are picking up as the business cycle matures – forces that would naturally lead to a higher term premium.
In our base case, the rebuild of term premium will likely be gradual (Exhibit 8). We have assumed 10-25bp of additional ‘premium’ in 10-year yields in the main bond markets we forecast. That said, we estimate that, despite diverging policy rate expectations across regions, the international spillovers of premium are higher now than at any point in the past two decades (Exhibit 9). Moreover, in some markets, such as Germany or the UK, the demand for long-term bonds has been increasing with the price level of these assets. This opens the possibility of a reversal in these dynamics should yields rise and bond prices fall.
9. Europe Risk: Preparing for a Post-Draghi Europe
2018 will be an important year of leadership transition in Europe. As the ECB begins to wind down QE, political changes in 2019 loom large, notably the end of President Draghi’s term. European policy makers have taken notice. Ever since his “whatever it takes” speech and the subsequent launch of sovereign bond purchases in early 2015,EMU “breakup risk” has steadily declined back to pre-crisis levels (Exhibit 10). That said,an uncomfortable truth about the ECB’s successful pledge to “do whatever it takes” is the extent to which it has been personified by Mr. Draghi’s leadership in the mind of the market. At the same time, the institutional upgrade of the Euro area has stalled and populism has surged.Euro area reforms can be grouped in two broad categories, those aimed at ‘risk reduction’ among weaker peripherals, and those aimed at ‘risk sharing’ among member states. The former includes measures seeking to enhance the EU’s popularity in the eyes of the electorate and thus helping counter the rise of anti-EU parties. Examples include defense and migration-related measures, such as those advocated by French President Macron. We would expect the Euro area to implement some of these measures in the coming year, given both the urgency of issues such as the migrant crisis and the relatively limited amount of risk reduction they would require from weaker sovereigns.
We are are less optimistic about the policies in the second bucket, namely, reforms designed to help contain a future crisis by enhancing the Euro area’s resilience to shocks. These policies – e.g., the upgrade of the ESM and the completion of the Banking and Capital Markets Unions – would call for significant risk-reduction efforts among peripherals (reduction of NPL exposures and sovereign bond holdings, structural reform in domestic markets). Moreover, ongoing political developments such as Brexit negotiations, Italian elections, government formation in Germany, and tensions in Catalonia, threaten to delay the reform process and weigh on market sentiment.
On net, we are optimistic that stronger growth, limited event risk, and the desire to calm populist forces in the Euro area should set the stage for institutional upgrades in 2018, which in turn should generate tailwinds for European assets. The risk is that if growth slows and rates move higher, the Euro area will increasingly be assessed on the basis of its resilience to shocks. The success of the reform process in the coming year clearly warrants careful attention.
10. Late-Cycle Imbalances: Illiquidity Is the New Leverage
The late-cycle search for yield often leads to financial market imbalances. In the last cycle, the search for yield drove investors to apply high leverage to structures that featured some pretty dramatic mismatches between maturity and liquidity. When runs on funding forced an unwind of those structures and trade positions, it set in motion a downward spiral in prices. The market’s collective memory of that episode is so widely known that it has become almost a cliché to recite it.This time around, illiquidity is the new leverage. In the current expansion, the search for yield has been equally intense, but the lessons learned in the crisis have discouraged a repeat of past mistakes. Instead of seeking levered exposure to low-spread assets with high Sharpe ratios, the search for yield has driven investors to earn incremental yield by leaning harder into liquidity premium – “anything without a Cusip”. Examples include private equity, private debt, direct lending, and commercial real estate (CRE), among others. The compensation for owning illiquid assets has consequently compressed,which you can see, for example, in the differential rate of return between CRE and real Treasury yields (Exhibit 11). This decline in the liquidity premium has shown some restraint, but has nonetheless fallen to levels lower than all but the pre-crisis lows of
This observation does not necessarily mean illiquid assets will contribute to the next crisis. On the contrary, the silver lining of this shift in the search for yield is that investors appear to have deployed far less leverage than in the last cycle. In contrast to the pre-crisis period, long duration, illiquid assets are again owned primarily by long-horizon investors with long-term funding. Pensions, endowments, private wealth, specialty hedge funds and insurance companies comprise most of the investor base,and with the important exception of insurance companies, these investors use far less leverage than banks and hedge funds. And in many cases, such funds are actually sitting on cash. So in the event of a sufficiently large market drop, there is reason to think there is money on the sidelines that could step in to seize such opportunities and cushion a market sell-off.