As we move deeper into the year, we see the potential for a change in the direction of the prevailing wind across global markets and economies. Why? Big US tax cuts, synchronised global growth and strong earnings may face increasingly strong headwinds from US Federal Reserve (the Fed) rate hikes, rising inflation and protectionist threats. For now, the cycle tailwinds are stronger than the headwinds, but we believe this balance could shift as soon as the midway point of the year as the Fed continues to lift rates.
Tailwinds to outpace headwinds … but for how long?
It’s been an eventful start to 2018 for global financial markets. The 5.6 per cent rise for the S&P 500 Index was the biggest January gain since 1997. This was followed by the largest ever one-day spike in the CBOE Volatility Index (the VIX), the first 10 per cent market correction since early 2016, and a subsequent 8 per cent rebound. To top it all off, the US 10-year Treasury yield rose 50 basis points to 2.9 per cent – the highest since the taper tantrum of late 2013. Strong Q4 corporate earnings and a much larger-than-expected Trump fiscal stimulus provided the initial boost, but this was undone when a spike in average hourly earnings, released with the January payrolls data, triggered an inflation scare.
The end result? 2018 looks different from last year along a number of significant fronts:
- more fiscal stimulus adding to already strong global growth momentum
- labour market inflation pressures, centring on the US
- central banks becoming more hawkish, with the US Fed potentially hiking four times this year and the ECB preparing to wind down quantitative easing
- President Trump turning out less protectionist than feared during his first year in office – although he’s now implementing tariffs
- more market volatility, implying larger risk premiums across asset classes.
This adds up to a complicated late-cycle backdrop for markets. Our view is that, for now, the cycle tailwinds from synchronised global growth, strong earnings-per-share gains and fiscal easing outweigh the growing headwinds from monetary tightening and inflation pressures.
US Equities: Don’t throw caution to the wind
Our investment measures tell us to be cautious about US equities. Very expensive valuations in the US implies asymmetry in the return outlook, where the potential downside is larger than the upside. Other markets range from slightly cheap (emerging markets) to slightly expensive (Europe and Japan).
We’re scoring the cycle as slightly positive for global equities, but watching closely for any signs of US recession risk. Our base-case analysis is that the most likely timing for the next recession is late 2019/early 2020. This means it’s probably another 12 months or so until recession risk enters the market radar.
Our sentiment process was signalling that equities were overbought in late January. The subsequent market correction and partial recovery have taken most of our signals back to neutral. Overall, we still recommend a neutral allocation to global equities, with a value-driven underweight to the US offset by overweights to emerging markets, Japan and Europe. We’re also neutral on high-yield credit, where expensive valuation is being offset by a moderately positive cycle tailwind from low default rates and strong corporate profits.
Volatility strikes back
One of the main takeaways from the start to the year is that volatility is back. The VIX index of the S&P 500 Index expected volatility averaged just 11.1 in 2017, the lowest year-average on record. The combination of central bank tightening, rising inflation, protectionist pressure and geopolitical risks means that volatility is almost certain to be higher this year – something we have already experienced through the first quarter.
Our preference for the past few years has been to buy the dip, as broadly positive views on the cycle outlook supported equities and credit. For now, the cycle tailwinds are stronger than the headwinds, so we are still looking to add risk into market pullbacks. But we believe the headwinds will increase as the Fed becomes more aggressive, inflation picks up and profit margins come under pressure from rising labour costs. Buying dips will likely become more challenging as we move through the year and markets become more sensitive to recession risks.
Treasuries: Fair value in the US, expensive elsewhere
One of the stories of 2018 has been the lift in government bond yields. As of mid-March, the 10-year US Treasury yield has risen by 50 basis points in 2018, UK gilts are up 30 basis points and German bunds have risen 23 basis points. Only Japanese government bonds (JGBs) have bucked the trend, where the Bank of Japan’s yield curve control policy is keeping the 10-year yield below 10 basis points.
Our fair value estimate for the 10-year US Treasury yield is around 2.8 per cent. This is based on our expected path for the Fed funds rate over the next few years, plus the term premium. Our estimate includes our expectation that there is a good likelihood the US will experience a recession by 2020, which means the Fed will be lowering rates. At 2.9 per cent in mid-March, the US 10-year yield is marginally on the cheap side of fair value. Bunds, gilts and JGBs, however, remain very expensive on our methodology.
Scenarios update and our call for Q2
We recommend watching three potential scenarios for 2018, given the uncertainties around the outlook.
- Markets grind higher
The US Federal Reserve tightens interest rates three or four times by the end of 2018, the yield curve flattens and global equity markets rise, but slowly, in the face of headwinds. There’s a risk of an equity bear market from late in the year, and Europe, Japan and emerging markets outperform a soft S&P 500 in the US. - We see a blow-out rally
Despite their current lofty heights, markets continue to surge due to a dovish stance from the Fed. Growth also continues and inflation remains in check. In this scenario, the US dollar is weak, emerging markets do well and everyone from journalists to taxi drivers are euphoric. - The Fed blows it
The potentially negative path is that the Fed misjudges and tightens interest rates too much, crippling an already sluggish US economy. The key concept to watch here is ‘R-star’ – the estimated neutral level of interest rates when a country has full employment. If it turns out that the proper R-star is lower than the rate the Fed moves towards, then it’s quite possible that the US market already peaked in January 2018.
Our advice for investors is to be ‘leaning out’ as the risks increase. They should base their strategies on three building blocks with differing time horizons.
The first building block is to consider the macro-economic cycles that influence asset classes. The second—but least important—is to focus on valuations and the return potential across asset classes. The third is to factor in market sentiment by looking at price momentum versus contrarian indicators that could signal that assets have been overbought or oversold.
