- The coming period is characterized by strong outright economic growth, against the backdrop of a number of key risks. These risks include a decline in global liquidity growth, changes in discount rates, a slowdown in global growth momentum, and an increase in event risk. We have reviewed these risks in detail to provide investors with a roadmap to risk over the coming months.
- Event risk is ever-present in investment markets, however, the outlook for growth, liquidity and earnings will matter more. Whilst the outlook for growth momentum and earnings remain supportive of risk assets in the near term, global liquidity growth is likely to decline in the near term, and growth momentum may slow into 2018. Market participants remain focused on event risk at present, some of which is already priced into risks asset, rather than the likely decline in global excess liquidity, none of which is priced into markets.
- Any decrease in global liquidity growth, and especially USD excess liquidity growth, will have an outsized effect on liquidity sensitive assets, such as Industrial Metals and Emerging Markets, however the continued growth in the US and globally should allow growth sensitive equities to continue to outperform.
Global Liquidity Growth
Changes in global liquidity conditions, coming chiefly from changes in the level of monetary stimulus at a global and regional level, present the greatest risk to asset prices in the coming months.
The global economy needs liquidity to simply function, even ignoring any desire for growth. Excess liquidity (which we calculate as M1 Money Supply/ Real Industrial Production) is any increase in liquidity above what is required for the global economy to simply function. The most recent surge in excess liquidity growth began in late 2015, as central banks again injected liquidity into the financial system. This surge in excess liquidity growth has peaked, and is now rolling over. Over the past year, the major contributors to the rise in the global excess liquidity measure have been the PBoC, ECB, and BoJ. Contributing to the 2016 recent increase was a large increase in M1 Money Supply (the numerator) in China from late 2015, combined with lackluster industrial production growth and inflation globally over that period (the denominator). At present, global excess liquidity is still growing, at 2.5%. That is – liquidity is being added to the financial system, at a rate of 2.5% over the year to September 2017 – still a strong rate, though well below the rates of above 10% seen in late 2015 and 2016.
Refer to Figure 1 showing Global Excess Liquidity Growth through time:
If this excess liquidity is growing positively above trend, it helps create growth, and if this excess liquidity is growing negatively below trend (i.e. excess liquidity is contracting), it can detract from economic growth. This is evidenced by the relationship between the deviation from trend rate of global excess liquidity growth and global industrial production growth, whereby excess liquidity growth leads industrial production growth by 1 year.
Refer to Figure 2, showing the relationship between Global Excess Liquidity Growth and Global Industrial production Growth through time:
From the current point, the outlook for global excess liquidity growth is much less positive. The Federal Reserve is now firmly on the monetary tightening path, with a further rate rise all but certain at the December 2017 meeting. The ECB has announced its intention to taper asset purchases to €30 billion starting in January 2018, and the PBoC continues to selectively tightening liquidity conditions. With the exception of the BoJ yield targeting program, there is unlikely to be a further increase in liquidity from other major central banks in the near term, and more likely, quite the opposite. With global growth also rising, global excess liquidity growth will likely decline below trend.
Outright global growth is likely to remain robust in the coming years, as other drivers of global growth are now emerging to replace the liquidity growth that has been the major driver for the better part of the past two decades, most specifically productivity growth driven by capital investment, as discussed in our recent investment research Q4 2017 Deltec Quarterly Global Strategy Outlook: Mechanical Intelligence. However, the reduction in global excess liquidity growth will have significant implications for asset prices.
Through time, there is a relationship between global excess liquidity growth and the performance of riskier assets (e.g. Equities) relative to safer assets (e.g. Cash). As global excess liquidity growth begins to decline, riskier assets tend to underperform. Most importantly, none of this coming decline in global excess liquidity is priced into risk assets.
Refer to Figure 3, showing the relationship between Global Excess Liquidity Growth and the performance of Riskier Assets, proxied by the relative performance of Developed Market Equities vs Cash:
Furthermore, given the dominance of USD credit as a funding source, the status of the USD as a reserve currency, and the large percentage of revenues generated and goods traded in USD, USD Excess Liquidity matters even more. USD Excess Liquidity growth has been slowing, and has declined by 1.7% in the year to September 2017. The Federal Reserve is firmly on a tightening path, this reduction in USD liquidity growth will continue to weigh on global liquidity growth in the coming periods, and will extend to the medium term, especially in an environment of fiscal expansion. In this environment, those assets most sensitive to changes in USD liquidity growth are most at risk, especially Industrial Metals and Emerging Markets.
Refer to Figure 4 and 5, showing the relationship between USD Excess Liquidity vs the Performance of Industrial Metals and Emerging Market / Developed Market relative performance:
Those assets that are less sensitive to changes in interest rates and liquidity conditions are likely to be less impacted, particularly those that are exposed to productivity growth, however any decline in global and USD excess liquidity growth over the coming months will lead to an increased level of volatility across all risk assets in the short term, and leave asset prices at risk.
Article by Deltec Investment Research
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