The world can do more to stimulate growth than rely on monetary policy alone, and it seems globally everyone is ready and poised for some fiscal stimulus. A positive global fiscal impulse could materially increase risk appetites under both consumers and corporate institutions. The scale of the potential fiscal stimulus in the US and the sense it might follow through to Europe initially had a large impact on bond markets. So far, bond yields have simply reversed their “deflation premium”, and shows signs of mild reaction to expected interest rate announcements by the Fed, in stark contrast to the 2013 “taper tantrum”. Global growth expectations are centred around consensus estimates of an acceleration from around 3% global growth in 2016, to 3.5% in 2017 and 2018, and this looks like very realistic targets.
Moreover, the more synchronised global growth picture has reduced the unbalanced attractions of the USA and even though interest rate spreads still favour the relative safety of the USA relative to other (less safe) markets, they have not widened recently. The US dollar has consequently remained firm but not to the extent that credit conditions in Europe and emerging markets are tightening, which is a key indicator of fear of the stability of the credit markets.
On the commodities front we have seen recently subdued Chinese metals prices, dragging down resource prices around the world amid worries that demand for iron ore and steel in the world’s No. 2 economy is weakening and inventories filling up.
On 4 May, the closely watched price of iron ore on the Dalian Commodity Exchange closed down 8% (at the daily trading limit set by the Dalian Exchange). The same was evident on the Shanghai exchange during trading hours where steel-rebar futures plunged 6.2% to 2931 yuan a ton, wiping out the prior week’s gains. In London on the LME, nickel fell in excess of 2% as well as the volatility in the Chinese metals markets rippled out across the world.
Should we take more risks now that we see global synchronised reflation? Trumponomics is pro-growth in basic orientation and in theory, Republican control of both Houses of Congress has broken the legislative logjam and should ease the implementation of some of Trump’s agenda points or at least improve the likelihood of it happening (full and final repeal of Obamacare etc).
Tax reform will be next on president Trump’s agenda and executives and industry will welcome this across the USA as their tax rates have crept up in the last decade or so to land the USA is Corporate Income Tax Rates the third highest general top marginal corporate income tax rate in the world, at 38.92%. Rectifying this situation can only be stimulative for the economy and can further stimulate cross-border trade because of improved trading conditions. If the USA does lower tax rates, and significant savings are not made anywhere else, we can logically deduct that their deficit will increase, hence the net effect resulting in even more stimulus. This has proved a welcome fiscal policy lead in a world that is ready for fiscal stimulus. Government spending (as a means to an end of an era of austerity) is necessary to consolidate the gains made since the financial crisis.
Janet Yellen and the Federal Reserve has also done a reassuringly good job of adjusting its positon to the improving economic circumstances, mitigating the risk that it is perceived to be behind the curve. With that in mind, we can expect the following in respect of Interest Rates in the USA: Janet Yellen suggested we could expect a rate hike in June after the Federal Reserve in the USA announced on Wednesday 3 May ’17 that it held its benchmark interest rate steady after a two-day policy meeting, as was widely expected. This is a reasonable outlook in the face of a waning of this year’s pulse of commodity inflation.
Risks we are still facing…
The Trump Presidency continues to pose new risks
President Trump may yet choose populism over pragmatism in his approach to global trade, but it looks like a lot of his stances has softened or became more balanced of late, but in the US the anti-growth part of president Trump’s agenda (protectionist by nature) could win over the pro-growth part (deregulation and tax cuts). Any sudden shift of expectations toward a faster pace of Fed rate rises could spook markets, but we have not yet seen this phenomenon rear its head. Trade wars could result in very severe consequences. These risks appear much reduced recently. Headline-grabbing “America First” policies are to be expected, but so far, “watching what he does” rather than “reading what he tweets” has been reassuring.
This is specifically so in the relationship with China, which is a litmus test of Trump’s choice of populism over pragmatism. His rhetoric on the campaign trail will necessitate some action (he may put his touted 45% punitive tariff on a symbolic import, for instance) but he has un-pressed the “One China” hot button and appears more focused on getting China on-side to address North Korea than to make a new enemy. Labelling China as a “currency manipulator” (which would open the way.
For the President to impose unilateral tariffs, but would not necessitate it) is still possible, but this is a high-risk strategy.
But to put things in context: China depends on the US in a way the US does not depend on China in that nearly 4% of China’s GDP comes directly from exports to the US, while the equivalent figure for the US is less than 1%. This can of course over time change as China becomes more consumer centric but immediate trade tariffs can severely damage China’s vast workforce, which inevitably is getting older due to the changing demographics. Relationships with Europe are also strained, but once again, it is hard to see where the benefit lies in provocation. It is entirely possible Trump is using his threats on currency and trade as leverage in his call for the US’s allies to share the burden of common defence. Cool heads are so far prevailing! In this vein, although we do not know the shape of the proposed tax package, a rumoured Border Adjustment Tax component is a possible point of friction. From an investment perspective, long-term damage here could more than offset any short-term boost from US domestic reflation.
A regime change is also underway in financial markets
The last stages of a 35-year bond bull market have seen investor behaviour reminiscent of that in the equity market at its peaks in the tech boom of 2000. Having seen safe haven bond yields driven to multi-century lows, the danger is that related assets have been mis-priced as yield hungry; risk intolerant investors have been inevitably tempted out of their natural homes into equity risk in search of income.
We expect a more volatile period as reflationary forces gain ascendancy. This should ultimately be a good thing for equities but there is a real possibility that both equity markets and fixed income markets fall in tandem if bond yields move up more quickly and reach higher levels than investors feel comfortable with.
If Global improvement in economic conditions are not held up or consolidated, upward pressure on the US dollar will increase, and consequently, if the dollar moves too much, it will become a headwind for global growth as it puts pressure on all the foreign dollar denominated debt (borrowing countries of whom many are emerging economies and institutions), who must repay their borrowings with depreciated local currencies.
The equity/risk valuation does not look cheap but in fact appears reasonable under the circumstances – if you employ reasonable assumptions of earnings earnings growth, inflation and bond yields, and outside the US things are looking more affordable i.e. there is a healthy risk premium built into these returns all things considered.
In Italy we could see some risks still persist as Beppe Grillo’s Five Star movement gains ground, but with Matteo Renzi back in the saddle after being re-appointed as leader of the ruling Democratic Party (PD) in the latest primary vote. Renzi is the centre-left candidate for prime minister in the next general election, which will likely occur in early 2018.
Moreover, we still have Russia’s annexation of the Ukraine, which remains unresolved, Syria’s Bashar al Assad’s use of chemical weapons and Russia’s unequivocal protection of Assad’s regime.
Sentiment, volatility and hidden leverage
The CBOE Volatility Index (VIX – a measure of US stock market volatility) and other volatility indices in currency and fixed income markets are all at low levels. It is hard to see them moving lower!
Shiller’s valuation metric shows the market in the US at least, as expensive, with nominal dividend yields low, and corporate earnings being boosted by share buybacks, which adds to leverage and is unsustainable.
Market structural strength: given the withdrawal of market making capacity, the high level of thematic crowding (bond proxies i.e. property), the stampede behaviour of “flash” trading platforms and the elevated share of equity markets being run by “hedge funds/quants” (fast money), and ETFs mean that the potential for a technical correction, perhaps turning rapidly into a 1987 type event, cannot be discounted (we have already seen flash crashes in the equity and bond markets; they were very short lived, but this may not always be the case).
The existence of multiple risk factors and the low margin for error makes it more likely that if one thing goes wrong, it will lead to another, compounding the impact.
Brexit…the evolving story, with inflation and the impact it has on the consumer being felt as big job decisions loom in the City of London as to where Euro Clearing should take place, with the housing market showing signs of cooling.
Gold: Should we be overweight gold as a hedge for implied volatility? Alternatively, is it time for investors to keep emotions in check and make cool-headed investment choices as volatility also can present opportunity for which investors must be prepared to take advantage of.
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