It’s been a tough first half of the year for many markets, and I don’t think it’s going to get any easier.
In my year ahead outlook, I wrote that 2018 would be difficult given the removal of central bank largesse. The chart below illustrates how investors have switched from having $300 billion of quantitative easing-funded capital to deploy in 2017, to having to find $700 billion to absorb the net sovereign debt issuance in 2018. What the chart doesn’t show is that this tightening is likely to accelerate throughout the year as US Federal Reserve (Fed) quantitative easing (QE) reinvestment decreases and the European Central Bank moves to its final taper.
This tightening is already playing out in the international funding market, where cheap leverage has been used to buy higher-yielding assets – not least in emerging markets. Crucially, negative events and headlines that would have been brushed off by markets when central bank printing presses were running, are now having a detrimental impact. And structural issues such as excessive global debt, weak productivity and political populism are all rearing their ugly heads.
However, economic growth and corporate earnings have so far remained resilient. This is encouraging the Fed and other central banks to keep withdrawing liquidity, maintaining pressure on vulnerable markets.
This stress could increase further if inflation accelerates. We are fully paid-up members of the lower-for-longer club, given the structural global weight of excess debt and deteriorating demographics. But there is every chance of a cyclical burst of inflation in the coming months driven by tightening labour markets, higher oil prices or even the rise of populist policies resulting in significant fiscal loosening.
We are focusing on slowing global trade as a leading indicator for broader economic activity. Partly as a result of the political tensions stoked by the Trump administration, this is likely to be an emerging markets story to begin with. Indeed, Chinese trade is currently in President Trump’s crosshairs. This is happening at the same time as domestic authorities are attempting to slow their enormous debt accumulation. The world’s second largest economy has been the creator of much of the world’s debt in recent years and can, therefore, heavily influence global asset prices, funding conditions and trade. The key question is whether the Chinese authorities will press ahead with deleveraging, or will they relent once the negative implications become visible?
All that being said, corporate fundamentals are still robust, and we have seen capital expenditure gathering pace. If this trend broadens, risk assets could emerge from monetary tightening relatively unscathed; however, more share buybacks and mega mergers/acquisitions could lead to higher leverage and greater vulnerability to an eventual economic slowdown.
Expect higher market volatility to weigh on confidence
What’s priced into markets? Many equity markets have fallen from the highs they reached in early 2018, and credit markets have suffered significant corrections. But while valuations are generally no longer eye-wateringly expensive, they’re not cheap either. As liquidity conditions continue to tighten and these themes play out, we suspect investor sentiment will deteriorate. Importantly, we expect higher market volatility to weigh on business and investor confidence, influencing the timing of the next economic downturn.
(For a more detailed discussion of the investment themes, please see my latest CIO outlook.)
For a small economy, Greece has kept European economists like me very busy, particularly at times of economic and political stress. Here are my key takeaways from a recent trip meeting policymakers, investors and analysts.