Something feels different
Bracing for a bumpy ride in this spring’s markets
Correction of exuberance or canary in the coal mine? Shakeout or shakedown? Hiccup or harbinger?
After a quarter of higher volatility and lower stock prices, the alliterations abound to describe the central challenge for investors this spring. Will we look back on this period as the last best opportunity to lock in the gains from a nine-year bull market or was this just a natural adjustment on the way to still higher returns?
In many ways, the answer should be simple. The macroeconomic outlook remains essentially supportive of synchronized growth, which should almost by definition be more durable and rewarding than periods when regions take turns as locomotive to an otherwise weak global economy. Economic forecasts in Europe, Asia and the Americas are still almost all in positive territory, with the IMF revising estimates for 2018 and 2019 higher still. Some 120 countries that account for three-quarters of the global economy saw an acceleration of their growth rates through the end of last year, according to the Fund’s economists. Past performance is no guarantee of future returns, but it’s hard to see a sudden, significant recession in the current data.
Still, there is a natural sense of unease and uncertainty around accelerating growth with few signs of inflation. The recent volatility, in many ways, reflects investor confusion around any data point that might suggest generalized price increases. Surely, there will be inflationary pressures from higher commodity prices, looser fiscal policy or trending wage growth. Surely central banks won’t manage to exit their extraordinary measures without falling behind the curve at least a little. The sharp eyes will be keenly focused on this dynamic in the months ahead, while listening closely for the sound of over-leveraged firms going bust as the price of money glides higher.
The political story, as usual, is more complicated. The U.S. Administration continues to surprise allies (and presumably rivals) with policy departures on national security and trade, the ultimate shape of Brexit remains as uncertain as ever and consequential elections loom in Indonesia, Mexico and Brazil. Flashpoints in Korea, Iran and Venezuela could still spark much larger conflicts or humanitarian crises if diplomatic initiatives unravel. Russia is growing more isolated and hostile, too. Yet it’s hard to see how even this much political and strategic drama with shake markets short of open warfare.
Economic optimism and political chaos have characterized the balance of risk through most of the last few years and markets managed to deliver impressive returns. Yet the disruptions in the last few months suggest that the trajectory may be more volatile as the bull run ages. No, bull markets don’t die of old age, but they do ultimately find it more difficult to rise amid headwinds from central bank tightening, extended balance sheets and narrowing profits.
American Signal vs. American Noise
If investors were uncertain of what the Trump Administration might deliver on Inauguration Day in January 2017, they are barely more confident after 14 months of watching events unfold. There is so much noise, that the signal is hard to detect. Amid the expanding Russia investigations, sudden Cabinet changes and tawdry personal accusations, the economy continues to hum along. But there are worrying macro trends to consider.
For all intents and purposes, there will be no more major legislation coming before mid-term elections this fall and the prospect of a more productive Congress after that looks dim. This leaves investors to stare hard at the economic data itself, which is mostly sunny with only distant clouds to mar the outlook. The Fed now forecasts 2.7 percent growth this year, declining slightly in 2019. Inflation seems to hover around 2 percent, in spite of higher energy prices and a budget deficit headed above 5 percent of GDP following large tax cuts and minimal changes in government spending. How best to close the deficit — through taxes or spending— will likely emerge as the central economic issue in coming political campaigns. The unemployment rate continues to trend down below 4 percent, although this may hide some slack in the economy as some workers would welcome more hours or better jobs. Any surprising shifts above current wage and price trends would lead to a significant change in market expectations. Another worry is the leverage that seems to be building up throughout the system. Household savings continue to trend lower and corporate leverage continues to rise. Even rates that rise gently and predictably will start to put pressure on vulnerable borrowers, and any unexpected hike will surely claim victims.
Three things to watch: inflationary pressures, bankruptcies and the emerging debate around how to close the budget deficit.
2. Europe’s Political Renaissance
One wouldn’t want to oversell this, but Europe has delivered a remarkable period of political unity: a common line negotiating Brexit, rising solidarity in the face of policy uncertainty in Washington and a stunning display of diplomatic unity standing up to Russia’s involvement in the poisoning of its former spy on a British park bench. This is hardly the hapless and disjointed political animal of the last several years. The challenges remain daunting and include successfully concluding a deal with Britain that retains access to a crucial export market, shaping a coherent German voice from a weak new governing coalition and keeping Italian populists from derailing progress on European institutional reforms. Rising trade friction with the United States poses a worry, but so far the threats of tariffs from Washington have been watered down and seem in any case to strengthen European resolve.
Meanwhile, the economic news continues to be mostly good. IMF forecasts of 2.0 percent growth still lags the United States, but includes slight acceleration in Germany, the Netherlands and Italy. Even Greece, still in desperate need of debt relief, has been posting growth as periphery bond spreads continue to tighten. European unemployment is still falling and inflation remains mostly at bay as the European Central Bank continues to chart an ever so gradual path toward an exit from its quantitative easing. Progress toward an end of open-market purchases would calm the inflation hawks and relieve concerns over dwindling market liquidity in safe assets. Stock market returns for all this good news have continued to be disappointing, although part of this comes from a euro that has gained some 14 percent over the last year and eroded foreign profits which are so important in Europe. Still, the market still trades at a discount to the U.S. which offers some greater downside risk protection as market volatility returns.
Three things to watch: fresh disruptions from Italian politics, continuing German paralysis and the ECB’s emerging exit strategy.
3. Brexit Doesn’t Concentrate the Mind
“Depend on it, sir,” said Samuel Johnson, “When a man knows he is about to be hanged in a fortnight, it concentrates his mind wonderfully.” Yet with Britain’s exit from the European Union now just 14 months away, there seems precious little concentration. Vague talk of a new referendum seems fanciful and agreement on a transition period that extends existing trade relations through 2020 answers few questions about the long term. Large banks and financial firms are still scrambling to understand the impact on their businesses and the consequences for financial markets. As long as most primary issuance and secondary trading remains in the City, the likely changes seem manageable, but it’s hard to imagine European Union’s regulators will sit back and allow their own firms to tap financial markets in a country that is entirely outside their jurisdiction. The heavy hand of continental financial regulation remains a significant long-term risk to the British economy.
Near-term economic news, has been relatively encouraging, as the pound’s sell-off has helped boost exports and support domestic demand. The beleaguered British government upgraded its forecast for this year to 1.5 percent growth. (It remains the slowest in the G-20, according to the OECD’s estimates.) The current account deficit of 4.1 percent last year was the smallest since 2011 on strong international demand for British exports. The Bank of England raised rates in November for the first time since 2008, but with inflation running at 2.7 percent some are beginning to expect a new hike in May. Still, the greatest economic uncertainty remains political both at home, as Prime Minister May clings to a thin parliamentary majority, and abroad, as future trading relationships turn more uncertain than ever. The going still looks tough for equities and the currency.
Three things to watch: further inflationary pressures, more corporate relocations to the continent and the potential for a palace coup (although not at the Palace itself).
4. Green Shoots of Japanese Inflation?
It was just last October that Prime Minister Shinzo Abe emerged triumphant from a snap election he had called to help push through constitutional reform and bolster Japanese defense. Today, however, his popularity has plummeted in the wake of a corruption scandal that involves the sweetheart sale of state land that implicates his wife and has been linked to the suicide of a finance ministry official. At the same time, the broader regional picture been more than a little tumultuous amid rising tensions on the Korean peninsula and escalating trade friction between the United States and China.
Yet the ‘three arrows’ of Abe’s economic plan for economic recovery may finally be delivering results. In the strongest expansion in decades, Japanese growth has been picking up with the passage of a supplemental budget that boosted domestic spending and strong export demand, especially in Asia. Corporate capital spending and a steady currency have also helped underpin the strong performance. Yet the efforts to boost inflation towards the government’s 2 percent target continue to fall short amid low wage growth. The Bank of Japan continues to press ahead with quantitative easing even as its European and US counterparts plot their exits. Now that Governor Haruhiko Kuroda has been reappointed to a new term, there is no end in sight for supportive monetary policy. Hopes have been disappointed before, but there may now be further pressure to raise wages with unemployment at a 24-year low of 2.7 percent and signs that consumer confidence is improving. The ‘third arrow’ of structural reform (monetary and fiscal measures are the other two) has also brought some greater openness to Japanese corporate governance as companies start to publish return on equity targets and add independent directors. Inflows into Japanese equity funds have also reached a 5-year high, suggesting that stocks may edge higher in spite of the political drama.
Three things to watch: exports, wages and Abe’s poll numbers.
5. China Steady, But Not Necessarily Ready
The greatest uncertainty around Chinese financial assets remains the prospect of escalating trade tensions with the United States. President Trump has announced plans for tariffs on steel and aluminum that could indirectly affect China and on another $50 billion of Chinese exports to retaliate against theft of U.S. intellectual property. Even if fully implemented, these measures cover only a small fraction of the trading relationship and so far many of the Administration’s announcements have been significantly delayed and watered down in the implementation. The risk remains that political pressures on both sides of the Pacific force further escalations and retaliation that expand the impact. The initial victims will likely be financial assets, which may sell off amid the uncertainty around how far the trading relationship might deteriorate.
The second major risk to Chinese markets comes from the vast and opaque network of debts that have underpinned the country’s growth, especially its real estate and state-owned enterprises. The government announced earlier this month that growth this year would be 6.5 percent, which is down from last year’s 6.9 percent — but exactly in line with what the government had announced last year’s growth would be. Given the vagaries of Chinese statistics, it’s not worth quibbling with policy that looks like more of the same. Politically, the most important trend seems to be President Xi Jinping’s consolidation of power and the prospect, after recent constitutional changes, that we may be in for quite a long period of his brand of continuity. Still, the government may find itself scrimping this year with an official budget deficit target of 2.6 percent down from 3.0 percent. This may require significant reductions in spending on infrastructure given simultaneous plans to boost defense outlays and cut taxes as well. Shrinking government resources may also make it more difficult to step in to save financial institutions that teeter on collapse as in the February response to irregularities at insurance giant Anbang. Even if the risks are rising, however, it’s hard to argue with fairly reliable 6.5 percent growth and a government with a coherent plan.
Three things to watch: more interventions in troubled financial services, more retaliatory tariffs on US imports and more tension over a nuclear-free Korean peninsula.
6. Emerging Markets: Still Everyone’s Favorite
Emerging Markets delivered strong returns in both equity and debt in 2017 in spite of global political turmoil, continuing tightening of monetary policy in developed markets and plenty of domestic political drama. Any forecast for more of the same depends on continued strong economic growth and only gradual increases in U.S. interest rates. Both seem likely as far as the eye can see (albeit not very far), with growth even picking up slightly outside of China. Rising commodity prices should also help.
The outliers include Turkey and South Africa, which suffered from poor policy and political turmoil last year. Turkey remains awash in easy credit that has kindled inflationary expectations and forced the currency lower. South Africa managed a significant course correction with the ascension of Cyril Ramaphosa as president and slight improvements in business confidence and growth. The most worrying visible risks on the horizon will be in crucial late-June local elections looming in Indonesia, which will measure the strength of President Joko Widodo’s reforms as he prepares for re-election in 2019. A few days later, Mexicans elect a new president, which could transform their relationship with the United States even further if populist Andres Manuel Lopez Obrador is successful. Finally, in October presidential elections are due in , where former President Luiz Inacio Lula da Sivla remains popular in spite of a legal ban on running in connection with his corruption conviction.
1Q18 Results: Short S&P 500 (-1.2% and down roughly 9.2% from Jan 26 high), Long USD (-2.2%); Short FTSE (-8.2%) and GBP (+3.7%); Long Stoxx 600 (-4.7%), Short EUR (+2.5); Long Nikkei (-5.7%), Short JPY (+6.08); Long China (CSI 300)(-4.6%), Long RMB (+3.6%); Long EEM (4.1%).
2Q18 Calls: Short S&P 500, Long USD; Short FTSE and GBP; Long Stoxx 600, Short EUR; Long Nikkei, Short JPY; Long China (CSI 300), Long RMB; Long EEM.
Christopher Smart is a Senior Fellow at the Carnegie Endowment for International Peace and the Mossavar-Rahmani Center for Business and Government at Harvard University’s Kennedy School of Government. He was Special Assistant to the President for International Economics, Trade & Investment from 2013–15 and Deputy Assistant Secretary of Treasury for Europe & Eurasia from 2009–13. He is also Associate Fellow at Chatham House.