The macro trends remain positive, but have gained an inflationary tilt - owing to the recent pro-business, pro-cyclical US tax reform, as well as the risk of rising trade barriers. The latter in particular could keep volatility elevated. We have thus decided to reduce our interest rate risk and further raise cash, while reaffirming our flexible approach in equities.
Our economic outlook has changed little from the previous quarter, although it has become slightly more inflationary for the developed markets (DM), while shifting further in favor of the emerging markets in terms of growth momentum (EM).
Specifically, in our baseline scenario, economic growth remains synchronous around the globe. Although momentum is naturally slowing, the DM continue to grow mostly above potential and are running into capacity constraints - which supports investment, reduces unemployment, and hence lifts wages over time. In the US, the tax reform that was passed shortly before Christmas further underpins the cyclical expansion by bolstering household and corporate earnings, albeit at the cost of widening the federal fiscal deficit. The cyclical outlook remains positive in Europe and Japan as well.
As a result, both actual and expected inflation rates are either already at targeted levels (U.S.), or rising towards them (Eurozone, Japan). Hence, the Federal Reserve’s strategy of a gradual (and clearly data-dependent) monetary policy normalization was reaffirmed and should eventually spread to the other economies, albeit perhaps not as quickly as the recent strengths in the euro and the yen seem to imply. Either way, owing to - finally - being on target in a stable manner (graph 2), the Fed remains firmly in the lead when it comes to tightening monetary policy. Unsurprisingly, on March 22, the Fed raised the federal funds rate target range by 25 basis points, to between 1.5% and 1.75%. The Fed’s median rate projections for the next two years have also rose by slightly more than 25 basis points, while the estimated long run policy rate moved 12.5 basis points higher, to 2.875%, implying five hikes of 25 basis points each over the next three years.
Last but not least, in the EM, China’s cyclical upswing has surprised on the upside recently, perhaps supported by the notion that the recent concentration of political power helps underpin confidence in the country’s ongoing reform and modernization process. More broadly speaking, most EM have only recently re-emerged from the commodity slump of a few years ago, and are still in an earlier stage of their business cycle, with inflation trends still clearly below target in most cases (graph 3). In short, the emerging economies offer more room for a cyclical catch-up before running into similar capacity constraints as the developed world.
On the downside, the U.S. administration’s recent trade policy initiatives have turned more unabashedly protectionist in tone and method, although perhaps not in terms of their intended final outcome. On March 8, Washington announced conditional across-the-board steel and aluminum tariffs, aiming to strong-arming both allies and rivals into trade concessions in areas ranging from cars to intellectual property and investment. On March 22, the U.S. added substantial additional tariffs on Chinese imports. In principle, these trade issues can (and probably will) be resolved in the various trade agreement renegotiations, and are thus not likely to significantly stymie global trade and growth.
The U.S. is already involved in trade negotiations with a number of countries and allies (Canada, Mexico, Europe, Japan, etc.), which provides the context for the tariff threat. With regard to China, the U.S. negotiating approach may prove counterproductive due to the strategic rivalry between the two powers. However, Washington’s core grievances versus China are largely shared by Europe, Japan, and most of the remaining ten members of the Transpacific Partnership (TPP), which makes concessions from Beijing more likely.
Nevertheless, the U.S. administration’s aggressive tone could gradually erode market sentiment more substantively, and/or trigger meaningful retaliatory measures from China and perhaps other major economies at some point. In our alternative scenario, we thus now see the risk of a stagflationary setback, i.e. an economic slowdown with higher inflation. In that sense, the geopolitical and political risks are now slightly more pronounced than before.
In markets, our concerns regarding the potential build-up of unsustainable euphoria, expressed following our last quarterly review in December, proved justified, as volatility levels have risen from exceptionally low levels back to a level that is more normal for mature bull markets (graph 4). The past quarter’s selloffs have thus helped wipe out some extremely one-sided positions in markets (e.g. the short-volatility strategies), rolling back investor complacency. From a behavioral finance perspective, markets have actually become more attractive. Valuations meanwhile have come down quite markedly during the first quarter, thanks to a combination of higher expected earnings for the year and the broadly unchanged level of stock prices on an index level (graph 5). The price-to-earnings ratios are broadly where they were at the start of 2016, when the period of extraordinarily low volatility began. These factors are in turn balanced by a deterioration of technical trends.
The resulting picture is admittedly mixed, but not negative. Hence, we stick to our strategy of combining a modest overweight in equities with defensive and anticyclical elements - i.e. to hold elevated cash reserves in order to be able to “buy the dips” (and “sell the rallies”) during market exaggerations.
Note: The next edition of the LGT Beacon is scheduled for mid May 2018.