Peter Geikie-Cobb provides an update on his market views and outlook for 2018.
After a robust performance for risk assets in 2017, as a result of strong global economic growth driven by continued low interest rates and ample liquidity, the outlook for this year looks somewhat more uncertain. Many asset classes look expensive at a time when central banks have either started or are about to embark on a tighter monetary path. There are also a number of issues such as trade wars and geopolitical events that markets have to consider.
While 2018 has started with a somewhat more soggy tone in terms of economic activity, and much of this might be weather related, this was not unexpected given last year’s performance. We would anticipate a modest slowdown in global GDP for this year and a rise in inflation back to or even above central bank target rates.
The US economy is certainly in the late cycle stage but should continue to expand, boosted by recent tax cuts and full employment. While we think that the Fed could tighten further than what is currently discounted by the market, interest rates are likely to peak at modest levels from an historical perspective, clearing out some of the zombie community that has been able to survive post crisis and thus leaving a healthier economy in the longer term. In Europe, the economy is in mid cycle and looks set fair for now as the ECB are behind the Fed in terms of the tightening cycle. The UK has defied the down beat forecasts of the OBR and the Treasury and with continuing employment gains looks to be reasonably solid, if not very exciting. Improving government finances will give the Chancellor a bit more wiggle room in terms of fiscal policy. Lower debt levels in the EM economies relative to DMs is positive, particularly in Asia.
As mentioned above, there are many things to be cautious about and the key factor remains the level of global debt, which has increased by $68 trillion (50% of global GDP) to $237 trillion (327% of global GDP) since 2008. This is unsustainable in the long term, particularly as interest and bond rates start to rise. As mentioned earlier, in the shorter term this will cause significant headwinds as individuals and corporates who cannot survive higher borrowing costs will be flushed out of the system, but longer term the constituents that survive will make up a much healthier economy.
We expect bond yields in the G7 to rise from here and peak about 125 basis points higher from current levels in this cycle. In the US, bond markets are discounting an inflation rate of just above 2% (core CPI is currently running 2.9% 3 months annualised) which is far too complacent in our view. Wage inflation is on the rise, with evidence from the small business survey NFIB, showing significant labour shortages. If the Fed is slow to react to this outlook, the long end of the bond market would be adversely effected, pricing in a central bank that is behind the curve at time when the deficit is increasing and the demand for US Treasuries from overseas investors is reducing. Assuming the Fed takes a more hawkish stance, we would expect a flatter yield curve but either way yields are going higher.
In terms of risk assets, we believe that we are close to a regime change in terms of what we expect for future performance. The assets that have benefitted from the abundance of liquidity since 2008 (bonds, both sovereign and credit, and growth stocks) are likely to underperform the assets that have lagged (value stocks).
In terms of currencies, the trend for the USD is not that obvious as the greenback will come under increasing pressure from foreign investors repatriating funds in the environment we describe but will benefit from wider interest rate differentials and US corporates returning offshore USDs back home following the recent tax proposals. If we are returning to a market place where fundamentals and value become the key drivers then GBP looks undervalued and we would expect USD/GBP to reach 1.50 and GBP/EUR to rally to 1.20 (note that GBP/EUR has just broken out of its recent 1.1100-1.1475 range and the upper end of the last 12 month channel)
In conclusion, we are debating whether the markets are on the cusp of a regime change whereby the fortunes of assets that have benefitted from the extended liquidity cycle versus those that have not are about to reverse. In this scenario, and from a high level, assets that would benefit are short dated US Tips/inflation linked bonds and value rather than growth stocks. For UK based investors, we think GBP is still oversold and will return to fair value/equilibrium. We expect high volatility to be the norm in this environment against a backdrop of trend economic growth and inflation mildly above target.