We’ve been down this road before – the going’s good in the market and the majority of investors just can’t foresee a change of current circumstances. If only we didn’t need to build the roof while the sun is shining.
Mind the Gap
A synchronised upward swing in global economies has created a liquid, stable market, with low volatility. However, lurking under the surface are economic conditions that are far from reassuring. We are seeing weak growth figures and an exorbitant debt burden – meanwhile markets are sailing along unreservedly. Specifically, recent research from Macquarie demonstrates that the global recovery from the 2008 GFC has achieved the weakest US post-recession recovery growth rates on record at ~2.2% real and 3.7% nominal – the slowest of all expansionary cycles since 1947. To put this into perspective, in the 1991 recovery period, the same figures were closer to 4.0% and 6.0%. Over the same time- frame we see that the ratio of global outstanding debt to global GDP has practically doubled – from 151% in 1990 to 300% in 2017. This yawning chasm between real and financial economic strength has the potential to destabilise current market conditions as soon as the second half of 2018.1
Investors are growing complacent – believing that central banks will not pass policy changes that would add turbulence to current market conditions. Meanwhile, the ECB financial stress indices and St Louis Financial Stress Index plunge towards historically lowest-ever levels, with certain constituent parts (including high-yield spreads and FX and bond market volatilities) reaching levels close to the 2000 dot.com bubble and that of the 2007/08 GFC. High Yield Spreads have drifted to a jaw dropping 300bps vs. the historic average of approximately 600bps – a strong indication of placid market participants. 1
Central Bank Stickiness
Central bank policy across the globe has contributed to this incontrovertible dislocation between financial markets and economic fundamentals. CBs in Asia, Europe and the US have been pumping liquidity into the market – creating a dependency on public sector support. Fearful of destabilizing the progress made, CBs have avoided tightening monetary policy – failing to create the space for private sector market forces to take centre stage.
H2 2018 – Volatility Rising
Continued excess leverage can only lead to worse rates of growth and inequality. As rates rise, giant debts will be harder to facilitate and maintain. In a worst case, albeit not impossible, scenario defaults on these debts could have the power to trigger the next wave of liquidity crises. Although the financial system is more resilient this time around, the impact will still be significant – and will again lead to more damaging outcomes in the real economy – through housing and wages, for example.
While central banks continue pumping liquidity into the market (around US$80bn-90bn per month (net)) the conditions will remain supported. However, in the second half of this year we will see the Fed contract monetary support further and in Europe the ECB plans to end its €30bn per month asset acquisition program. Alongside the forecasted interest rate rises, tightening will contribute to a higher cost of capital and most likely lead to volatility drifting, possibly lurching, higher in the second half of this year. In short, go long.1
1Macquarie, What caught my eye? v.86, January 26th 2018