“Your loving give me such a thrill
But your love don’t pay my bills
Now give me money
That’s what I want”
Money – Barrett Strong, 1959
Ten long years after the crisis, volatility and fear seem to have disappeared from financial markets. A synchronous global expansion coupled with persistently loose monetary policy has produced a goldilocks environment for all assets. Will it work for another year?
We have reasons to be cautious. Investors are not only searching for yield in bonds and stocks, but increasingly betting that volatility in asset prices will stay as low as it is today. Several economists and strategists have called this an environment of rational exuberance. Volatility and asset prices are justifiably low, they say, given healthy macroeconomic conditions. Believers in rational exuberance think central banks will continue to provide stimulus and that inflation will remain contained.
Yet there are chances that investors may instead be in a period of irrational complacency.
The signs of complacency and irrational behavior are widespread. Stock market realised volatility is at a 50-year low. The yield on European high yield debt has fallen below the one of US Treasuries (although it is still higher, including hedging costs). Developed and EM countries have issued 100-year bonds. The market cap of Facebook, Amazon, Apple, Netflix and Snapchat combined exceeds that of the DAX. Financial leverage is back, extending to collateralised debt obligations on bonds. Cash-park assets including property in large cities, art, collectibles and cryptocurrencies are soaring with a parabolic slope.
There are chances that tomorrow will be just as good as today. Markets have so far focused on the stock of $20tn in central bank assets rather than the flow of purchases, which may turn negative next year. Even though central banks are withdrawing stimulus, growth is positive, financial conditions are still easy and liquidity is still flowing into risk assets.
That said, we believe the risks of a rise in volatility are growing, given the crowded one-sided positioning of investors in the same bets relying on market calm and tight yields.
This is why we believe investors must be cautious entering the New Year. We see three main risks which may break the current goldilocks environment: a return of inflation, a hawkish turn in central bank policy and geopolitical risk.
1.Inflation Surprises: The Fast and The Furious
Leon: “We got cops, cops, cops, cops!”
The Fast and The Furious, 2011
Inflation has remained elusive in 2017, despite continued monetary stimulus and disappearing output gaps. Stable inflation, long-end interest rates and term premia underpin a number of carry trades in rates, credit and currencies – a fast and furious return of inflation could bring volatility back.
How could it happen?
A first driver is fiscal stimulus. Over the first half of 2017, we saw a build-up in expectations on US corporate tax reform, which faded over the summer. This month, we are finally close to getting an economic boost from tax cuts. In Europe, the Merkel-Macron alliance post French elections provided a similar outlook, but recent negotiations in Germany have thrown cold water on the prospect of imminent fiscal and political integration. In the second half of 2018, however, and especially in the scenario of a grand coalition with CDU and SPD, who has been more vocal on European integration, we believe the final result will be more positive than markets fear. Finally, China was the big engine of global disinflation from 2012 to 2016. Continued price increases, similar to 2017, coupled with further renminbi strength could translate into rising export inflation, which the world has not seen in quite some time.
Many investors fear a China debt crisis, as public reserves ($3tn) start to be overshadowed by the amount of bank non-performing loans, shadow banking defaults and other losses by state-owned enterprises ($1.5-2tn). But this analysis doesn’t include China’s private wealth amount, which at $23tn is more than enough to support growth and economic rebalancing. Finally, Japan is showing tentative signs of inflation awakening; the government has recently considered declaring victory on inflation, albeit that may not come until later in 2018.
Aside from fiscal stimulus and supply-side inflation, demand could accelerate: even though interest rates have been low for years, the bank credit channel is only now starting to accelerate and lending to the real economy in Europe. Bank regulators across the world have been focusing on raising capital over the past few years, and this process may have finally reached a peak. Eurozone bank balance sheets have now declined to below 300% of GDP to €30tn from €35tn and over €250bn equity has been raised. The credit channel, more than market conditions, is what matters for small and medium businesses which generate nearly 80% of new jobs in the Eurozone, and more jobs mean eventually higher wages.
Finally, commodities may stage an unexpected comeback, despite persistent overcapacity. Fears of a Chinese deleveraging remain overdone, as discussed above, and OPEC members are as in need as ever to boost oil prices, given higher political tensions in the Gulf. This could see oil moving towards $70 per barrel.
Our base case isn’t an aggressive spike in inflation. However, the political push for fiscal stimulus across the US, Europe and Japan could be significant, if coordinated. This, coupled with increased bank lending and higher commodity prices could shift core inflation closer to 2% and move expectations higher, at a time where central bankers have almost thrown the towel on inflation and have become more hawkish regardless of it.
2.Central Banks Change Tack: Ocean’s Thirteen
“Back to macro. What is your exit strategy? The players won’t be in on the scam, so they’ll all think it’s their lucky night. But you’ll never get them out the door with all their winnings. They’ll dump it all back. That’s Vegas, and that’s your problem.”
Ocean’s Thirteen, 2007
What if central bankers decide to bring volatility back?
One reason to do so is financial stability, with the risk that persistent loose policy may be encouraging a number of collateral effects on the economy and markets. These include asset bubbles in interest rate sensitive assets, like bonds, high dividend stocks or property; but also a misallocation of resources to asset-dependent and leverage-heavy industries, like real estate or energy. The Bank for International settlements has long argued about these collateral effects, and the potential deflationary consequences of keeping interest rates too low for too long, causing an asset bubble-burst cycle.
Another reason why central banks may be more cautious is politics. While monetary stimulus supported the recovery and job creation, it has also boosted inequality and disparities between the haves and have-nots, across geographies and between small and large corporations. As a result, continuing QE is becoming increasingly difficult, as shown by the political pushback in Germany, for example, or across the US.
A final reason for central banks to withdraw stimulus is to build a policy buffer for a future slowdown. In light of upcoming changes in leadership at the Fed in 2018 and future changes at the European Central Bank and at the Bank of England, we think investors should prepare for a more out-of-the-money central bank put option.
In the movie Ocean’s Thirteen (2007), Danny Ocean’s team simulates an earthquake under the Casino they are trying to rob – prompting gamblers to run out from the exit door. This is how markets could look like on a sharp central bank policy change of tack.
3. Political and Geopolitical Risks on the Rise: WarGames
David: “Is this real or is it a game?”
Joshua: “What’s the difference?”
The most important risk we worry about long term isn’t market positioning but politics. Rising inequalities between the haves and have-nots across society and geographies are fuelling a polarisation in politics. The result is populist regimes, which generally carry three common elements: they pursue a dream, create an enemy to point people’s angst at, and pursue unsustainable economic policies.
The Trump Administration’s dream to revive America’s past industrial success, or the UK’s dream of a global Britain are both attempts to defy economic gravity in a world of global supply chains. Similarly, calls for independence across European regions to revive their past glory, ignore the need to pay for government infrastructure and security.
But even if political slogans are shifting further away from reality, the resulting policies are likely to have a real impact on the economy. Looking at historical examples, fiscal spending, protectionism and military activity are the most likely outcomes of populist regimes in the medium-term. All of them would be destabilising for markets used to low volatility and low inflation.
Brexit’s disruption to the UK’s trade, or the Trump Administration’s threat to exit NAFTA are two examples of protectionist policies. The bigger, fundamental question remains open around the future sustainability of neoliberal capitalism, as we wrote recently on the World Economic Forum. Capitalism has been incredibly successful at generating resources, but has failed to redistribute them. Absent policies to improve social justice and to redistribute opportunity, the drift from democracies to flawed democracies or authoritarian regimes is likely to continue (see left).
Polarised politics in turn can generate geopolitical conflict. We look at three hotspots where tensions could escalate in 2018: China, who continues to expand its projection of power in the seas of South East Asia; Eastern Europe, under the shadow of Russia’s infowars and guerrilla tactics; the Middle East, where the Saudi Kingdom is fresh out of an internal purge and tensions with Iran continue to rise.
United States: Late Cycle Euphoria
“Some folks are born silver spoon in hand
Lord, don’t they help themselves, oh
But when the taxman comes to the door
Lord, the house looks like a rummage sale, yes ”
Fortunate Son – Creedence Clearwater Revival, 1969
We think the Congress will pass tax cuts by Q1 2018, despite the risks of President Trump’s impeachment. Senate Republicans hold a fragile majority and are in disagreement with their House counterparts on the components of the tax bill. While we appreciate these challenges, we believe Republicans are aware of their need to demonstrate progress to their constituents ahead of mid-term elections, especially in the face of an unpopular President and the risk of losing seats to Democrats or more populist Republican candidates. Therefore, we expect Republicans will elect for the tax-path-of-least resistance, and the tax cut will cost less than $1.5tr over 10 years (or $1tr if existing cuts are extended), in line with the Byrd rule. Therefore, the stimulus to the economy would be $100bn per year or, maximum, 0.5pp of GDP.
We expect three Fed rate hikes next year in our base case. The Fed’s current hiking path has been the shallowest in post-war history and is now potentially behind the curve. We therefore expect that next year, as with this year, the Fed will hike in line with its projections, even if inflation fails to accelerate. This bias towards over-hiking, rather than under-hiking is as: the economy is growing above potential growth estimates, labour markets are at or near full employment, tax cuts have not been factored in to the Fed’s rate hike projections and represent an upside risk to growth, the Fed needs to achieve an adequate rate-buffer before the next recession so as to avoid cutting into negative territory, and while the Fed has not labelled financial markets a ‘bubble’ it has indicated that prices are ‘elevated’. In our view, for the Fed to hike fewer than its projected path in 2018, we would need a meaningful slowdown in wage growth, markets signaling a high likelihood of a recession in the near-term (e.g. a complete flattening of the yield curve), or for political risks to impair economic confidence or inflation expectations.
Tax cuts will support growth in 2018, acting as a tailwind to both consumption and capital spending. By most measures, the economy is at the beginning of the late-cycle. Traditionally, this would imply that growth should start to moderate, though remain above potential of around 1.7-1.8%. Over the last two years, the US had a strong tail-wind from consumer spending, which rose with falling savings rates. Consumer spending may have further legs, as a tax cut boosts disposable incomes, raises financial asset prices, and consequently household wealth. Tax reform may also incentivise capital spending, which gradually recovered from the lows of 2015 when profits of commodity and exporting companies were squeezed by a stronger dollar and weaker prices.
After 2018, slower economic activity and an ageing cycle may outweigh the benefits of a tax cut. Firstly, with fewer job gains and potentially only moderate wage growth, consumer spending is likely to slow. Secondly, MIT research has highlighted that corporates invest when they see an economic opportunity rather than because of lower interest rates, taxes or easily available credit. Therefore, higher capital investment from lower taxes, may only be temporary. Finally, the Fed is likely to have hiked three times before year-end, and as a San Francisco Fed member illustrated, economic expansions don’t die of old age, they’re murdered by rate hikes.
Wage inflation may rise only gradually next year, constrained by a recovery in workforce participation rates. This year, unemployment declined but wage growth decelerated. This deceleration may be as labour slack still persists in the economy. A proof of this slack is in the low participation rate of 25-54 year olds. According to Fed data, nearly 2.6pp was shaved off this demographics’ participation rate from 2008 to 2015. But since 2015, over a third of this participation has recovered, signifying almost 1.3m working-age individuals re-entering the workforce and looking for jobs vs around 3.5m of total jobs created. In other words, a third of labour demand was met by new supply, thereby lowering the need to raise wages. Therefore, wage growth’s evolution depends on whether the outstanding 1.5-2pp of participation slack will re-enter the workforce or not. Next year, there is potential for some participation recovery, and therefore slower wage growth, if higher capital expenditure and better wages for low-skill jobs entices some men back into the workforce, who have lagged women in returning to the workforce.
Fundamentally, a lower working-age participation rate is likely to persist unless structural inequality is addressed. While inequality has been high in the US for the last three decades, it has been further exacerbated by central bankers’ response to the financial crisis. Global QE helped fuel an asset price recovery which increased the divide both between asset-owners vs income-earners, and also amongst asset owners (e.g. since 2008, house prices are up 20% in San Francisco, down 15% in Camden, NJ). One consequence of this growing inequality may have meant fewer opportunities to access education. As low skill jobs face growing competition from technology, the inability to attain a college degree may have been a key contributor to a lower participation rate as this demographic has dropped out of the work force the fastest. With nearly 2/3rd of jobs estimated to require a college degree by 2020, a policy response may be needed to tackle this structural driver of declining participation.
* * *
Portfolio Construction in a Frothy Market
Timing the consequences of a withdrawal of central bank liquidity has proved difficult. However, as asset prices continue rising to new highs, investors need to be increasingly cautious about asymmetry, liquidity and correlation.
Asymmetry of returns is particularly evident in long-dated government bonds trading at negative yields or below inflation, like UK Gilts; or in high yield markets where the credit cycle is turning for the worse, like US high yield.
Trading liquidity conditions remain scarce at points of increased market volatility. Passive investing has grown, which means increasing one-sided risk and herding, as confirmed by IMF data. In addition, passive structures like high yield ETFs embed a mismatch between liquid liabilities vs the less-liquid assets they buy. Finally, banks are unlikely to become the liquidity providers of last resort, as regulatory pressure remains high.
Asset correlation has declined over the past years – we are far from the days where a crisis in one European country would lead to a read-across in others, or a high yield default would make the whole sector widen. Today, markets’ reaction to shocks remains generally idiosyncratic.
These observations bring us to position our macro portfolio in the following way:
1. Improving the liquidity profile: for example reducing the portion of corporate credit held in cash form and adding to synthetic positions as substitutes. This brings a double advantage: cash credit has tightened more as directly targeted by central bank purchases, so it may reverse with more widening if they stop abruptly. Synthetic credit is also more liquid and can be more easily unwound in a downturn.
2. Positioning in assets that provide symmetric risk-returns: only a few niches of credit markets remain cheap – including Greece, bank subordinated debt in Europe, some Emerging Markets (Argentina, Ecuador), and a few high yield sectors. That said, credit still brings limited upside to investors. Equities, on the other hand, while generally not cheap, can provide more upside in a re-pricing and rotation scenario. The rotation from technology stocks to financials over the past few days provides an example of what could happen, should our inflationary or hawkish central bank risk scenarios materialise.
3. Hedging for rising inflation expectations, tighter monetary policy and higher political risk. It is an expensive strategy to hedge on a systematic basis; however, there are ways to position for increased correlation across assets, or a change in regime between asset correlations which may be cheaper, after many months of stable markets. In credit, our favourite way of doing this is to extract yield from jump-to-default risk in junior tranches and hedging spread volatility with mezzanine or senior tranches.
Economist Rudi Dornbusch used to say that crises take longer to come than you think, but when they do, they happen much faster than you would have thought. This has been my experience in 2007-2008 and later on with the European crisis, starting in 2011.
Today, we believe the largest risks are not in banks, sub-prime debt or excess balance sheet leverage. While regulators have been focusing on strengthening bank capital over the past decade, investors have been incentivised and guided to take more first and second-order risks on the level and volatility of asset prices. These risks are harder to quantify and lie in financial markets rather than in banking institutions under the direct supervision of regulators – yet, they exist, and can become a threat to financial stability.
Left unchecked, another financial boom-bust cycle could have unprecedented political consequences. Persistent central bank easy policy has stimulated job creation but also increased inequalities between the haves and have-nots, the young and the old, between large financial centres and the peripheries which were left out of the recovery. The American Dream that many aimed for over the past decades appears broken, and in this context, another round of QE will be politically difficult, should the economy slow down in the future.
Rising inequality may provide fertile ground to populist politics, as it already has done in the United States and the United Kingdom. History shows us that periods of monetary debasement go hand in hand with social and political crisis, as we wrote recently in the Financial Times. The late Roman Empire shaved silver coins as it disintegrated; the British Empire allowed double-digit inflation to erode bondholders’ wealth following the War of Independence; the Weimar Republic precipitated an inflation spiral. Populism means excess spending, higher public debt, inflation and losses – particularly for fixed income investors.
Investors will need to navigate this environment carefully: avoiding asset bubbles, positioning for monetary policy normalisation and protecting themselves against a change of political and fiscal regime at the end of the QE era.
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