Bumps in the Road
Our economic scenario
The outlook for global growth has softened somewhat in recent months. Corporate confidence surveys had reached unsustainable highs and some levelling off was likely. Also, worries about tit-for-tat trade sanctions have dominated headlines. This being said, our core 2018 scenario is still quite bright – the US and the eurozone should register steady, above-potential growth; the extended transition period before Brexit has provided some clarity for UK businesses; China is expected to slow only gradually; and more constructive trade negotiations have commenced.
One of the initial triggers for the market sell-off in early February was inflation fears linked to US wage pressures. In addition, household and market expectations for higher prices have firmed. However, the pace of US wage increases has eased and central banks show little sign of worries about inflationary pressures – recent forecasts from the Federal Reserve (Fed) and the European Central Bank (ECB) suggest only moderately higher levels in coming years. All in all, we do not expect inflation to soar but to trend moderately higher at both headline and core levels.
As widely expected, the new Fed chair Jerome Powell hiked interest rates in March but signalled no change in direction. We expect two further increases this year – three if the Fed begins to see signs of fiscal-induced overheating – but this gradual normalization will still leave monetary policy at stimulative settings. The Bank of England looks set to hike rates again this year, following the Fed’s pattern of a long pause before the second increase. And the ECB will complete asset purchases before considering higher rates, meaning no hikes before spring 2019 in our view.
All in all, momentum in global equity markets has stumbled, leading us to recommend scaling back exposure to more neutral levels in late February. This being said, the solid global growth outlook is likely to see corporate profits rise at double-digit rates this year. In addition, investor complacency has been shaken by the spike in volatility, often a prelude to better opportunities ahead.
At the World Economic Forum gathering in late January, the International Monetary Fund upgraded its world growth forecasts for this year and next. However, its chief economist also observed that “… the overarching risk is complacency… we might be closer to a recession than you think”. Why would he mention complacency? And why might it be a concern?
Stability leads to instability
In recent years, gross domestic product (GDP) growth has exhibited lower volatility than in previous decades – i.e. the changes from one year to the next have been much more muted.
American economist Hyman Minsky hypothesized in the early 1980s that such periods would lead to greater risk tolerance and to more leverage, leading in turn to an economic boom1. And booms tend to become unstable, leading in due course to busts. This insight achieved great prominence during the aftermath of the subprime lending crisis.
Measures of business or investor confidence – such as the global Purchasing Managers’ Index or Germany’s ZEW – are useful leading indicators of trends in economic growth. The PMI survey is designed so that levels above 50 points are indicative of expansion in output and those below 50 of contraction (recessions typically occur when the PMI dips below 45).
Throughout 2017, PMI confidence strengthened markedly across the board, reaching cycle highs in many major economies and suggesting that synchronized economic expansion would continue. However, such highs in optimism do not tend to last and, although recent surveys remain well above 50, they have suggested some softening in growth momentum.
Higher volatility should be no concern
Like the global economy, financial markets experienced an extended period of quiet trading. The MSCI World index of global equity prices made positive total returns each month from October 2016 to January 2018. This raised investors’ animal spirits, with this January seeing the sharpest rise in prices in recent years. Since then, markets have corrected,
penalizing momentum, a key component in our VaMoS framework. As we have suggested in recent monthly House Views, this warranted a reduction in exposure to global equities to a more neutral level.
One of the clearest signs of the bumpier road has been the spike in the S&P 500’s VIX implied volatility index. This measures the cost of hedging via options on the index – higher costs suggest high risk aversion and low levels the opposite. The VIX fell to 11.1% on average in 2017, by far the lowest level recorded since the Global Financial Crisis. The sharp market corrections since early January 2018 have seen volatility spike again. Indeed, the 2018 year-to-date average of 17.2% is higher than the 2017 peak of 16.0%!
In our view, this return to higher volatility should not be a cause for concern. Rather, it should be viewed as a return to more normal market conditions. The 2018 year-to-date average is in fact lower than the average since 2007, which stands at 19.8%.
Market turmoil offers buying opportunities
The global economy has experienced an extended period of steady low-volatility growth in recent years, while global and US equities had an exceptionally long run of positive, low-volatility returns. In Minsky’s framework, the shifts to more variability in leading economic indicators and to higher volatility in equity markets are the logical consequence of the preceding calm.
This reversal to more normal conditions has cured some of the complacency shown by investors, and global equities are now more attractively priced than at end-January. And given we expect the robust expansion to continue and to generate solid earnings growth, periodic spikes in volatility and sell-offs in equities are likely to provide buying opportunities.
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1 “Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.” Hyman Minsky, The Financial Instability Hypothesis, 1982.