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 U.S. tax cuts, synchronised global growth and strong earnings may face increasingly strong headwinds from U.S. 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.
Q2 forecast: Tailwinds to outpace headwinds … but for how long?
It’s been an eventful start to 2018 for global financial markets. The 5.6% 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% market correction since early 2016 and a subsequent 8% rebound. To top it all off, the U.S. 10-year Treasury yield rose 50 basis points to 2.90%—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, centering on the U.S..
- Central banks becoming more hawkish, with the U.S. 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.
U.S. Equities: Don’t throw caution to the windCycle, value and sentiment
Our cycle, value, and sentiment investment decision-making process tells us to be cautious about U.S. equities. Very expensive valuations in the U.S. 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 U.S. 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 signaling that equities were overbought in late January. The subsequent market correction and partial recovery have taken most of our signals back to neutral. Overall, our process still recommends a neutral allocation to global equities, with a value-driven underweight to the U.S. 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 pull-backs. 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 U.S., expensive elsewhere
One of the stories of 2018 has been the lift in government bond yields. As of mid-March, the 10-year U.S. Treasury yield has risen by 50 basis points in 2018, U.K. 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 U.S. Treasury yield is around 2.8%. 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 U.S. will experience a recession by 2020, which means the Fed will be lowering rates. At 2.9% in mid-March, the U.S. 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
Our 2018 annual outlook report, issued in early December 2017, recommended watching three potential scenarios for 2018, given the uncertainties around the outlook.
- Equity markets face increasing headwinds later in the year. Europe, Japan and emerging markets outperform the U.S. in what could be a relatively flat year for global equities.
Upside scenario: blow-out rally
- Fed is dovish and tightens by less than expected.
- Euphoria takes hold and investors leverage into the equity market
Downside scenario: Fed mistake triggers a 2018 recession
- Fed overtightens into a sluggish economy and R-star (the real interest rate consistent with full-employment and stable inflation) turns out to be much lower than expected.
The impressive January for equity markets suggested that the blow-out rally was underway, and there was plenty of anecdotal evidence about strong demand from retail investors at discount stock-brokerages in the U.S. However, we believe both market volatility and relatively hawkish comments by new Fed chair Jerome Powell mean that the blow-out rally is becoming less likely. In addition, while we see the Fed mistake scenario as still a possibility, the magnitude of the Trump fiscal stimulus and the growth momentum so far are pushing this scenario into 2019.
In short, we still favour the central scenario. Our outlook for Q2, therefore, has a similar refrain: Global equity markets push may push higher through the mid-way point of the year, before facing headwinds as the Fed continues to raise rates and investors start to worry about a recession in late 2019 or early 2020.
In other words, while the winds of change may not have surfaced yet, storm clouds are beginning to dot the horizon.