Quarterly outlook is mostly positive, but urges caution
Quarterly Outlook December 2017
The positives and negatives in the current market environment
We provide our latest perspective on economic conditions and the market environment in our end of September 2017 Quarterly Outlook. The Quarterly Outlook provides valuable insights into current trade-offs between risk and return as they follow from the Ortec Finance Scenario set (OFS).
In each Quarterly Outlook, we highlight a theme that is relevant to that particular issue. The Quarterly Outlook for end of September focuses on the current risk and return nuances that are visible over the short term. We argue that although there are several reasons to be positive about the short term, it’s a good idea to keep your head cool and also look at signs that urge caution.
So what does the Quarterly Outlook have to say about the positives and negatives in the current* market environment?
*Please note that whenever in this text or in the Outlook we refer to “current”, “at this moment” or equivalent references to time, we refer to the market environment as of the date of writing, which was end of third quarter, 2017.
Reasons to be positive about the short term
There are basically four developments that bode well for the near future: economic growth looks solid, inflation is low but not dangerously low, the search for yield continues to drive up asset prices, and there’s no foreseeable catalyst for correction in the short term.
Solid economic growth
The world economy is now in its eighth year of recovery since the financial crisis, and is projected to grow this year by around 3.5%. That’s a solid performance, which is close to the average rate of growth during the last forty years. Growth is expanding across the globe, world trade is recovering, unemployment levels are low and declining and business and consumer confidence are high.
Low inflationary pressures
Supported by the solid economic performance, central banks seem on the verge of phasing out their accommodative programs through a combination of rate hikes (U.S.) and (mostly) balance sheet reductions (or deceleration of balance sheet expansion). This could lead to increasing interest rate levels which could slow down growth. However, one important piece of the puzzle is missing still. Central banks of developed countries target an inflation rate of around 2%. By stimulating economic growth, they aim to bring down the unemployment rate which – according to economic theory – should then lead to increasing wage and price pressures. However, the relation that they assume to hold between the unemployment rate and the rate of inflation, the so called Phillips-curve, does not seem to be working at the moment. Therefore, central banks are expected to proceed very cautiously in the normalization of monetary policy and, as a result, the accompanying increase in interest rates is expected to happen only very slowly.
Search for yield
As interest rates remain low, positive momentum continues, and volatility remains low. More and more investors – many under pressure to meet hurdle rates – will be drawn towards risky assets in their search for yield. In such an environment, investors are also inclined to finance their investments by taking on more debt. Although valuation levels are already deemed ‘lofty’ by many, these forces could very well drive up asset prices even further, at least in the short term.
No foreseeable catalyst for a correction
Although there are serious risks which could spoil the party, at the moment there is no foreseeable event which could stop the current positive momentum from continuing for quite some time.
Reasons to be careful about the short term
Of course, the trends outlined here are by no means guaranteed. Uncertainty about the future is in itself reason enough to be careful. There are indications that some specific risks are strongly skewed downwards, making negative deviations from the expectation more likely than positive deviations. Three risks especially warrant attention. The information that underlies investment decisions may be unreliable, the drive toward more debt makes consumers, governments and banks more vulnerable, and there is concern that unexpected events could put an end to the positive mood, which could trigger more negative scenarios.
There are reasons to be suspicious about the reliability of information about the economy and financial markets that central bankers and investors base their decisions on. Central bankers have based their unprecedented monetary stimulus programs on the Phillips-curve, but this curve seems to have stopped working at the moment. Economic growth is solid and unemployment is low and decreasing, but wage and price inflation remain below target. The ultra-loose monetary policy, with its low interest rates and low market volatility, has forced more and more investors into risky assets in their search for yield, driving up asset prices to all-time highs and compressing credit and term spreads to levels that raise the question whether current asset prices still adequately reflect the underlying risks.
At the same time, the ultra-low interest rates stimulate consumers, businesses and governments to take on more debt. In the G20 countries, they now hold more debt than ever before: a staggering 135 trillion US Dollar. Emerging markets alone have taken on 300 billion US Dollar of additional foreign debt this year, twice as much as during the last two years. When compared to before the financial crisis, debt-to-GDP ratios remain high, or have even increased, especially so for China. Should for some reason the positive mood turn negative, then these high debt levels and the low interest rates at which they are currently financed can have reinforcing effects. Because their policy rates are already low, and they have already brought so much debt onto their balance sheets, central banks have little room left to manoeuvre in case of a next recession.
The third reason to be cautious are unexpected events that could switch the current positive mood into a more negative one. This could set in motion a chain of events leading to a more negative scenario than currently foreseen. In the current environment, policy and (geo)political risks could provide these potential triggers. The Brexit negotiations, for example, do not seem to make much progress, and nobody knows how they may end up. At the same time, the content and timing of the fiscal stimulus program of the Trump administration, as well as the outcome of its renegotiations of trade programs, remain unclear. A new Fed chair could change the course of monetary policy, and North-Korea continues to create tensions in the Asian hemisphere. Other triggers could come from foreign exchange markets: the recent appreciation of the euro could potentially slow exports and growth of the Eurozone.