Synchronised global growth – reason for cheer?
The late-2017 enthusiasm in financial markets about the economic outlook carried over into the new year. At the Davos shindig in January, there was much enthusiasm for the return of synchronised global growth. Christine Lagarde, the IMF’s Managing Director, boasted that “all signs point to a further strengthening [in global growth] both this year and next. This is very welcome news.”1
All signs point to a further strengthening [in global growth] both this year and next. This is very welcome news.Christine Lagarde, IMF
Is synchronised growth really welcome news? In a superficial sense, yes; it means that the vast majority of countries – and their citizens – are getting richer simultaneously, with their successes being mutually reinforcing. But the empirical evidence is less encouraging. Synchronised global growth has tended to occur during only three stages of the business cycle: the initial recovery from recession, the years immediately preceding the next recession, and ahead of some sort of financial crisis. While the economic expansion in the wake of the financial crisis has been relatively weak compared to history, we are well past the initial recovery phase.
All good things must come to an end
Over the course of January, investors appeared to be in agreement with Ms Lagarde, with global equity markets chalking up their best opening month since 1990. After January’s endorsement, February and March were less kind to those who had backed the rational exuberance narrative at the turn of the year. The best January since 1990 was followed by the largest spike in equity-market volatility since 1987 – a rude awakening following the catatonic state of market volatility throughout 2017.2
No doubt exacerbating the spike in volatility was the scale of the short volatility position that had built up in financial markets. Starved of yield, investors have looked for novel ways to generate a return, with the shorting of volatility (effectively betting on volatility staying low) being one of the most popular financial innovations of recent years.
However, volatility cannot be suppressed forever. When it began to rise during the first quarter, traders in volatility-related exchange-traded products (ETPs) were obliged mechanistically to buy more ‘VIX’3 futures to rebalance their books – the opposite of shorting volatility – pushing it higher still, which then spilled over into equity markets. In short, what appears to have begun as an inflation/monetary-policy scare was then driven further by technical/market-trading dynamics. By the time the worst-affected trading day (5 February) was over, a number of short volatility ETPs had collapsed in value and were liquidated, with one ‘inverse volatility exchange-traded note’ making headlines as it lost 96% of its value overnight, a reminder of how fragile some forms of financial wealth can be. 4
Sandy Rattray, the chief investment officer of Man Group, who jointly devised the formula to trade futures contracts tied to the Vix, observed that the sheer scale of trading in derivatives tied to stock-market volatility means that the “the Vix has moved from being a measure of something to being something that influences this thing it is trying to observe”5 – a clear case of circularity within the financial system. Given the extent to which volatility is a key input for risk-management systems used by banks and many investment strategies, higher volatility today is likely to be a headwind to asset prices and financial conditions in the future. True to the reflexivity of financial markets, higher volatility begets higher volatility.
The Vix has moved from being a measure of something to being something that influences this thing it is trying to observeSandy Rattray, Man Group
Putting Powell in perspective
In the wake of this spike in volatility, investors may have been persuaded to ‘buy the dip’, but over the rest of the quarter risk assets were not able to regain their poise as readily as investors have come to expect. Global equity prices ended up lower for the first quarter in two years, while credit spreads continued to widen. With markets having grown accustomed to the benevolence of central banks, those who looked to the Federal Reserve (Fed) for reassurance were left disappointed.
After being sworn into office on 4 February, Jay Powell, the new Fed chair, gave an upbeat assessment of the outlook for the US economy, noting that “unemployment is low, the economy is growing, and inflation is low”.6 However, Powell’s optimism was delivered against a backdrop of sharp declines in equity markets, with the S&P 500 index falling by over 4% on 5 February.
Unemployment is low, the economy is growing, and inflation is lowJay Powell, Fed
Prior to Powell’s comments, investors had grown increasingly concerned about the risk of an acceleration in US inflation, with those concerns heightened further by data showing an acceleration of year-on-year wage growth to 2.9%. Having largely dismissed the prospect of an increase in inflation over the course of 2017, the approval by Congress of a major tax-reform package in December was seen to increase the probability of a significant fiscal expansion and kindled renewed interest in the inflation narrative.
The reasoning goes that fiscal expansion in the latter stages of an economic expansion means that an already hot economy is going to get hotter. Despite having refused to play ball since the financial crisis, the ‘Phillips Curve’ (which depicts the supposedly inverse relationship between the level of unemployment and the rate of inflation) would inevitably start firing as ‘output gaps’ closed further, and as labour markets continued to tighten and stoke wage pressures, which in turn would feed through into rising consumer-price index (CPI) inflation. January’s average US hourly earnings number (+2.9% on an annualised basis) served to highlight the immediacy of this risk.
For the first time since the financial crisis, financial-market participants were confronted with the prospect of the Fed realising both its objectives: full employment and 2% inflation. Furthermore, after a protracted period in which the Fed has incentivised investors to take risks, financial-market participants may have been unsettled at the likelihood that the new central-bank chairman was taking the opportunity to burnish his credentials as man of action when it comes to managing inflation.
Powell’s desire to distance himself from the suggestion that monetary policy was governed by the equity market is likely to have stoked investors’ fears. Remarks from Bill Dudley, head of the Federal Reserve Bank of New York, that the market decline amounted to ‘small potatoes’ which would not impact his forecasts for the US economy or the course of monetary policy, will surely have only exacerbated fears further.7
As a result, investors have been prompted to question how quickly the Fed will now respond to declines in the financial markets. While we cannot know how policymakers will react, at the very least the strike price of the ‘Powell Put’ (the presumption that he would step in to prop up ailing financial markets) is further out of the money than Janet Yellen’s (his predecessor’s) equivalent.
Good Trump, bad Trump
What felt like turmoil in the financial markets was accompanied by yet more disruption in the political sphere. Following in the wake of tax reform, President Trump has renewed his focus on trade, in particular the US current account deficit vis-à-vis China, and investors were confronted with the prospect of a trade war between the world’s two largest economies.
Trade wars are not won by anyone. Of course, the exporting country loses from a trade war, but so too does the importing one. There are no winners in a trade war because it normally leads to the substitution of more expensive goods for cheaper ones. In effect, it denies consumers the efficiency gains that have been realised through the expansion of global supply chains.
One only has to go back as far as 2002, the last time steel tariffs were enacted, to see the potential for damage. Following a spate of mill closures and surging imports, President Bush implemented tariffs on certain steel products.The net effect on employment in the steel industry was minimal, but businesses that used steel products as inputs shed approximately 200,000 jobs (compared to the 180,000 employed in US steel production at the time).8 As a result of these tariffs, US manufacturing firms, in particular smaller companies, were subjected to higher input prices which eroded profitability. Being unable to increase prices, previously profitable companies were forced to cut production, and with it their labour forces, so while the intention of tariffs and trade barriers is to repatriate jobs seen to have been lost overseas, the outcome is often higher prices and jobs losses at home.
La Dolce Vita
The Italian election served up another reminder of the scale of dissatisfaction with the status quo in the West. 55% of Italian voters backed Eurosceptic, anti-establishment parties. Italy’s Five Star Movement, formed in 2009 by comedian Beppe Grillo, gained 32% of the vote to become by far the strongest single party in the country, while the Northern League, another insurgent force, carried 18.
Given that investor sentiment towards the eurozone has improved significantly over the last 18 months, the result serves as a reminder that economies like Italy’s are not structured to produce the output needed to deliver on the current social contract. Despite the improvement in the global economy, Italian youth unemployment is still just under 33%.9
Both parties have promised to roll back unpopular reforms implemented in recent years, in particular the 2011 pension reform which was intended to assuage market concerns about future fiscal incontinence. This is considered necessary to avoid a debt crisis.
It remains to be seen whether the European Union (EU) will accommodate further fiscal slippage in a bid to quell what is derisively referred to by those who constitute the status quo as a ‘populist uprising’, as it did in the wake of the UK’s vote to leave the EU. ‘Pork barrel’ politics are usually the course of action when politicians need to save their bacon (prosciutto). The Italian election result is the latest in a string of political developments that give us firm reason, in the context of our ‘divergence’ investment theme, to believe that fiscal policy will continue to play a greater role in economic management.
Not-so-synchronised global growth?
The Italian revolt appeared to be driven by a pervasive sense that the benefits of the country’s economic recovery, which compared with the rest of the eurozone has been weak, have accrued to a small minority; by disgust at taxpayer-funded rescues of a handful of Italian banks; and by unease at the arrival of more than 620,000 migrants into Italian ports over the last four years. As we have noted for some time, the asset inflation engineered by central banks would not serve as a panacea for the resolution of structural impediments to growth.
But what of the prospects for that other supposed economic panacea – rising consumer-price inflation? We remain of the view that the ‘inflation scare’ narrative will remain just that, a scare rather than a return of real inflation. Globally, drivers of structural disinflationary trends remain firmly in place. The fact that the historically inflation-prone emerging markets are benefiting from disinflation is a testament to how pervasive those trends are. Subscribing to the view that inflation is always and everywhere a monetary phenomenon, global money supply growth today is simply not consistent with a sustained acceleration of CPI inflation.
Perhaps there is risk of a cyclical acceleration of inflation. For all the talk of synchronised global growth at Davos, the first quarter of the year saw the extent of that synchronicity subjected to scrutiny. As well as typically occurring only during the initial stages of recovery and in the year immediately preceding a recession or financial crisis, periods of synchronised global growth have historically proven to be disappointingly ephemeral. Perhaps it is no surprise therefore that the first quarter saw the synchronised global growth narrative being called into question.
Can Goldilocks regain her poise?
The case for Goldilocks was built on solid, if uninspiring, growth, low inflation and accommodative central banks. Given that global equity markets started the year by delivering average annual returns in less than a month, some may suggest that the subsequent sell-off was a ‘healthy correction’, with the dip to be bought.
However, the poor returns from risk assets over the course of the quarter are historically consistent with slower economic momentum and tighter liquidity conditions. As policymakers continue to tighten monetary and fiscal policy, financial markets are likely to be subject to intensifying headwinds as economic momentum and financial conditions deteriorate further.
We noted last quarter that 2017 was a year of paradoxical tightening. Despite interest-rate hikes, measures of financial conditions actually continued to ease. We postulated that this was because central-bank asset purchases were the dominant factor in determining financial conditions, particularly when viewed through the lens of financial-asset prices. Over the course of the first quarter, however, collective central-bank asset purchases declined significantly as the European Central Bank halved its purchases to €30bn per month and the Fed accelerated the process of reducing its balance sheet to $20bn. On this basis, it is perhaps no surprise that risk assets have come under the cosh.
In the 1890s, biologist Ivan Pavlov was studying reflexes in animals, with dogs from the streets of St Petersburg as his subjects. Pavlov was interested in saliva, in particular how much of it is produced when different foods are eaten.
To Pavlov’s immense surprise, his dogs would salivate not just when they received food, but when they simply saw the men in white coats who brought it. Pavlov realised that the dogs had made an association between the lab coat and the arrival of food, and it was this association that produced the saliva reflex. Pavlov used this insight to condition responses to certain other stimuli.
It is not well known that Pavlov tried to reverse condition the reflexes he had instilled in his subjects, with the process often leading to the animals attacking the researchers. With policymakers having successfully conditioned market participants to pay inflated prices for financial assets on the basis that money was of little value, could the markets be about to bite the hand of central bankers as the latter attempt to exit extraordinary monetary policies and stop feeding the markets?
Wealth, savings and consumption are linked umbilically. When household wealth is rising, it bolsters consumption and lowers savings rates. In the absence of income growth, asset-price inflation has been the key driver of growth and consumption, particularly in the G7 economies. This effect has been most significant in the US, where households have a greater share of their financial assets in equities, and where house prices have been stronger than elsewhere. The US household savings rate has fallen from 6% as recently as 2015 to just above 2% at the end of 2016, but the same paradigm also holds throughout other major economies.
If financial wealth begins to shrink, the feedback loop goes into reverse: confidence is damaged, the burden of debt rises relative to falling asset values, and precautionary savings have to rise. We believe it is highly likely that the global economy will prove more vulnerable to declining asset prices than is suggested by the econometric models of conventional economists, and indeed, by the Federal Reserve. Economies have become ever more financialised over the course of three decades, with financial asset prices increasingly dictating outcomes in the real world. To us, the financial wealth that was apparently vaporised in the wake of the short-volatility implosion is a warning of how precarious the foundations of this economic expansion are.
Key investment risks
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2 Source: Bloomberg, April 2018
3 The VIX is a headline volatility Index which measures stock-market expectations of volatility implied by S&P 500 index options, calculated and published by the Chicago Board Options Exchange (CBOE)
8 Trade Partnership Worldwide study. The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002, 7 February 2003.
9 Source: Eurostat, February 2018.
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