Janus Henderson: Be careful, it’s getting late!

The big question

With the current bull market in risk assets now among the longest in financial history, questions are naturally being raised about longevity. The most optimistic scenarios tend to focus on the positive outlook for the global economy. Consensus forecasts still paint a reassuring picture of steady growth and moderate inflation over the next couple of years.This backdrop should help underpin current constructive market fundamentals, such as solid corporate earnings growth and low credit default rates. As things stand, the global ‘big picture’ is one of an unusually long economic cyclical expansion, with no obvious signs of recession and no clear reasons why current equity and credit bull markets should be coming to an end.  

Chart 1: Consensus World GDP growth and inflation (%)

Source: Bloomberg, as at August 2018. Red bars and dotted line represent current median consensus forecasts.

Of course, this is only one half of the story, and it is the easier half. Recent bull markets in equities and other assets have not just been driven by growth but also by the extraordinary monetary accommodation provided by major central banks in recent years. The picture here is more complicated than on the growth side, but one thing is clear: the monetary tide is turning. Whereas, last year, central banks injected around $2,000bn into financial markets through their asset purchase programmes, that tap is now being turned off. Over the next few months, the aggregate impact of the central banks will be to begin draining liquidity from financial markets for the first time since 2008, ending a decade of quantitative easing (QE) and beginning the new era of quantitative tightening (QT).

Into the unknown

The truth is we just don’t know how this shift from QE to QT will affect financial markets. The past decade’s QE has been an unprecedented financial experiment, leaving us with no meaningful historical comparisons to inform how this will all work out.Economic theory doesn’t offer much help either; academic opinion is fairly divided on how QE influences financial markets and the real economy. While some believe that the unfolding change in the global monetary regime will inevitably bring bull markets to an end, we do not think that the evidence on this is clear. We have more confidence in our long-held view that QT will alter the character of financial markets, ushering in a more challenging environment of lower returns, higher volatility and greater performance dispersion. In this regard, we see the behaviour of global markets in 2018 so far as being a reasonable guide to what lies ahead.

Watch wages

The uncertainty surrounding how QT will affect markets means that we have to remain flexible in our views, vigilant for any signs that the process is causing financial stress. For now, we take comfort from the fact that the unwinding of QE is likely to be very gradual and will take place against a backdrop of still exceptionally low interest rates. One key threat to this view would be if inflation began trending higher in the major economies, pushing interest rates onto a more aggressive trajectory than markets currently anticipate.While it is reassuring that measures of underlying inflation are still fairly subdued in the advanced economies, wage pressures are nevertheless stirring in the eurozone, the UK and, most notably, in the US. The potential concern would be if rising wage growth put upward pressure on inflation or interest rates, or if it undermined corporate profitability. While an upswing in wage growth would be less problematic if it was accompanied by a rise in productivity, we remain alert to the possibility of less market-friendly outcomes.

Trade tensions close to a peak?

Beyond these orthodox, late-cycle economic risks, escalating global trade tensions loom as the other large imminent threat to financial markets. While investors were pretty sanguine about the first round of trade disputes earlier this year, there has certainly been a sizeable market impact from the intensification of exchanges between China and the US in recent months. The key issue here is the scope for any further escalation in hostilities to damage global business confidence and growth. One related concern is the potential for adverse developments on this front to expose further frailties in emerging markets, which have already seen a number of sizeable setbacks in 2018.It is hardly encouraging that trade negotiations between China and the US seem to have ground to a halt. Still, while the outlook here remains highly unpredictable, we lean towards the view that financial markets have already priced in a lot of bad news on this front. While the US is not yet experiencing any economic pain from the tariffs imposed so far, further measures could have a meaningful direct economic impact on the US consumer. That might ultimately restrain President Donald Trump’s appetite for escalation. It is also worth noting that the US corporate sector is strongly opposed to the White House’s protectionist policies and is likely to become increasingly vocal as new measures are unveiled. While there are a number of long-term, strategic Sino-American clashes, it is nevertheless plausible that trade hostilities could end before tariffs are ratcheted up in 2019.

US vs the rest of the world

Looking within markets, one of the most notable trends of the year has been the extent of the performance divergence both between and within asset classes. Regionally, the big story has been the substantial outperformance of US assets over emerging markets in equities, currencies and, to a lesser extent, in credit. Over Q2 and Q3 for example, US stocks outperformed emerging markets by 23%.To a certain extent, these market moves reflect divergent economic fundamentals. The US economy has retained strong economic momentum throughout 2018, assisted by Trump’s fiscal stimulus. On the other hand, emerging market economies have lost momentum in recent months, under the weight of trade tensions, debt concerns and other influences. 

Chart 2: Revisions to JP Morgan GDP growth forecasts (%)

Source: Bloomberg, as at October 2018. Rebased to 0 as at end of December 2016.

We are wary of extrapolating these diverging macro fundamentals too far into 2019. It is quite likely that US economic growth will peak in the early months of next year as the fiscal stimulus fades and we begin to see the drag from this year’s rise in interest rates, higher bond yields, a stronger dollar and trade tensions. Furthermore, another support for US assets that is likely to fade into next year is the one-off, tax-driven repatriation of offshore corporate cash. The movement of this money has likely seen $400-$500bn flowing into US stocks and bond markets in 2018 via share buybacks and corporate bond redemptions. On top of this, a number of measures of valuation, investor positioning and sentiment are beginning to suggest that US outperformance is now looking fairly extended.While a significant reversion of this year’s trend is probably going to require the catalyst of some meaningful change in macro or market fundamentals, we do nevertheless feel that the best phase of US outperformance is now behind us.

Chart 3: Regional equity market performance (%)

Source: Bloomberg, as at October 2018. Total returns, rebased to 100 at end of December 2017.

A wide range of outcomes

Of course, the three topics we address above are far from independent. We would expect substantial interaction between developments on all three fronts, with significant implications for broader investor risk appetite. The following three potential scenarios show how things could work out from here.

• Fed shock – an acceleration in macroeconomic momentum that puts meaningful upward pressure on US interest rates. This would probably see a ‘blow-off’ move higher in US dollar and US equity outperformance against the backdrop of a generalised risk-off environment. It is likely that emerging market assets would be the big loser in this scenario. This broad-based de-risking, with few refuges other than the US dollar, would be a challenging environment for multi-asset portfolios.
• Trade escalation – for example, the US extending tariffs to 25% on all imports from China. This scenario would probably also involve a blow-off move in the outperformance of US assets and a generalised global de-risking. The key difference from the ‘Fed shock’ scenario is that government bonds would probably perform well in this situation, with markets expecting the associated growth shock to shift central banks onto more dovish paths. 
• Trade resolution – the US and China manage to de-escalate trade tensions before the US extends tariffs to all Chinese goods. This scenario would probably trigger a sharp reversal in the relative performance of the US dollar and US equities against the backdrop of an emerging market-led rally in global risk appetite. Government bonds would probably suffer as growth and interest rate expectations lifted.

At this stage, the range of plausible market outcomes is very wide. While our views still tend towards the more constructive outcomes, we recognise that the visibility of some key market drivers is unusually low and the cost of prediction error could be unusually high. Accordingly, our portfolios remain somewhat hedged against less favourable outcomes.

In our view, the era of buy-and-hold ended with QE and we are now in an environment in which asset allocation will be increasingly important. While, for now, our focus is on keeping our portfolios resilient, diversified and flexible, we do feel that some big asset allocation decisions lie ahead.