Markets Moving On From 2017's Bliss Point
Alex Joiner | Feb 22, 2018 15:57
Originally published by IFM Investors h2 IFM Investors Economic Update/h2
As 2017 ended, markets entered a bliss point with strong returns in a low volatility environment, little inflation and monetary policy settings that were expected to remain accommodative and relatively unsurprising. However, after an uneventful and buoyant January, the illusion was shattered in early February as equity markets
globally took a leg down. Consequently, volatility, as measured by the VIX index, spiked as high as 50 intraday – its highest read since August 2015 when a sell-off in Chinese equities reverberated through global financial markets.
With such an extended period of low volatility gains stretching valuations it is perhaps unsurprising a pullback was due. At the time of writing, markets were in the midst
of a rebound, although it is unclear if it will continue. Yet such corrections are not uncommon (although there has not been one for a while) and a correction is likely what the current episode represents – nothing more serious. We’d suspect that as long as the economic backdrop remains positive and there is an absence of any more acute
geopolitical concerns, these periods of volatility should arguably be short-lived. Much more concerning would be a spike in volatility when the backdrop is poor and
deteriorating – as yet not the case.
Indeed the current bout of volatility is largely due to better economic conditions that have been reinforced by the fiscal stimulus in the US that will bolster an economy that is already recovering well. Within this, early signs of a pick-up in US inflation and wages seemingly forced bond markets to reprice and this reverberated through valuations in other markets. The change comes after an extended period in which rates market did not believe the US Federal Reserve’s (Fed) economic outlook and refused to price the Federal Open Market Committee’s (FOMC) hiking expectations – this has been largely rectified, at least for now.
h2 US: Equity market and volatility/h2A pullback and volatility spike after a period of calm and growth
Despite it being reasonable for this volatility spike to dissipate it is equally reasonable to expect a potentially higher average level of volatility and increase incidents of
spikes going forward than we experienced in 2017, driven by a number of factors. Firstly, geopolitical risks remain around Brexit, the upcoming Italian general election, US
trade policy and escalating trade tensions between the US and China. Secondly, and the driving force behind the most recent market ructions, is markets grappling with
the potential of synchronous global economic growth resulting in the synchronous removal of monetary policy accommodation. The Fed started this trend (indeed, there
is now already emerging debate as to how far the Fed can go without choking off economic growth), with speculation the European Central Bank (ECB) will follow as early as late-2018 – and there’s even talk of the Bank of Japan changing tack at some point. This shift in stance and tone from the larger central banks is combined with other
smaller central banks, such as the Bank of Canada, Bank of Korea, Bank Negara Malaysia, and even the Bank of England who have all moved rates higher in recent months adding to the global narrative.
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But again this removal of accommodation globally is to be expected, as authorities become more sanguine about the outlook. Indeed, the FOMC’s forecasts suggested an
increase in bonds was likely should they come to pass.
Markets have just taken some time, and needed some evidence, to believe the Fed.
Nonetheless in the broader context we remain of the view that this is a cyclical uplift in bond yields rather than a secular one. A cycle around what we expect to be a
structurally lower average in the post-global financial crisis period. There are many compelling reasons to expect this to be the case. At the most simple level these are: the greater indebtedness of global economies; the ongoing dampening effect of technology (and other factors) on inflation; and the prospect of lower neutral policy interest rates. The latter encompasses weaker potential real GDP growth rates due to demographics and modest productivity growth.
Nonetheless in this cyclical episode questions around equity market valuations will continue to be asked. If this assertion is correct then bouts of higher volatility will become more common. In this environment, risk adjusted returns may suffer and asset allocations may need to shift accordingly. It has also underscored yet again that
the bull market in bonds has ended, and that returns in the government bond space in particular will be much less consistent. And even though as yields rise and bonds
become more investable, the risks seem to have become more elevated and symmetrically distributed across this space.
In such an environment we view infrastructure, particularly in the unlisted space, to be in an arguably favourable position compared with both of these asset classes for the
reasons outlined below:
• Unlisted infrastructure is a low volatility asset class with historically robust returns, which importantly has shown a low correlation with most other financial assets.
• We would argue that valuations in this asset class are less likely to be eroded by risk free rates than in the listed market. This is as assets are generally valued by independent entities who have historically taken a long-term view of discount rates for unlisted infrastructure assets. As such, valuations have not reflected reduced
risk free rates (as a component of their discount rate composition) as aggressively as may have been done in the listed space. This relationship inherently means that
the duration of these assets is lower as an increase in interest rates will likely not be immediately be reflectedin the discount rates used for asset valuations.
• Further, patient long-term direct investors in infrastructure, especially in open-ended funds, are less likely to ‘lever up’ assets as compared to other investors that may more aggressively gear assets, and are therefore less exposed to rising rates. Prudent hedging and risk management strategies also reduce this exposure.
• Finally, infrastructure asset returns tend to have characteristics of both bonds and equities, and have historically been structured to provide inflation protection characteristics to investors. Many sub-sectors within the asset class are also able to provide investors with additional economic exposure given revenue linkages to GDP or population multipliers. These factors provide a natural hedge or offset to increasing bond yields as they are the very drivers pushing them higher in the first place.
These factors are most compelling for investors that deploy capital on a medium to long term time frame and that can tolerate less liquidity than available in financial assets.
h2 United States: Growth trend solid/h2There was a buoyant mood to US activity data late last year and into 2018, aided by the passage of US tax reform through Congress. This tone was broadly reflected in soft data late last year, in particular with the ISM manufacturing index that rebounded in December to 59.7 – this was just under a post-recession high of 60.8 reached last
September. Employment, prices and importantly new orders sub-indexes were all strong – these data pulled back only slightly in January. The non-manufacturing index
dipped a little in December to 55.9 but recovered strongly in January to reach 59.9 – the strongest read since mid-2005.
Tax reform was a strong thematic in the Fed’s ‘Beige Book’ that also carried a relatively upbeat assessment of regional conditions. And economists agree with The Wall
Street Journal’s survey to identify upside or downside risks to real GDP growth forecasts recording its strongest ‘upside risk’ read since it started in 2015.
Importantly, tax reform has resonated with households as they have been a key driver of the recent economic recovery. The Conference Board consumer confidence
index confirmed this, rising to 125.4 in January and it remains elevated. This bodes well for retail spending that recorded another solid 0.4%mom gain in January, with upward revisions in previous months likely to also bolster Q4 GDP growth when revised. As it stands, the advanced read of Q4 GDP disappointed expectations with annualised growth coming in at 2.6%. Within this the consumer already made a strong contribution to this rate of growth, with spending expanding 3.8%yoy saar.
Inventories were a significant drag on growth, removing 0.7pp so we may expect a rebound in that space next quarter. Also, net exports subtracted 1.1pp from growth
after a strong increasing in imports overshadowed a good export performance – the former suggesting the domestic economy demand remains robust.
This solid rate of growth has been reflected in labour market data, with non-farm payrolls starting the year on a strong note adding 200,000 jobs, beating expectations
and holding the unemployment rate low at 4.1% (with stable participation). This labour market tightness, likely below full employment, has finally prompted some wages pressures. Average private hourly earnings have accelerated in recent months, reaching 2.9%yoy growth in the January read – a rate not seen since 2009. This trend
has been identified as a potential key driver of a stronger inflation pulse in 2018 and as such was at least in part responsible for the selloff in bonds.
However, to date these wages pressures have not been reflected in any material way in an acceleration of inflation. Indeed, after a solid rise in November, headline CPI
inflation was modest in December at 0.1%mom and this left the year-end rate of inflation ticking lower to 2.1%yoy. Yet core CPI inflation was stronger, the index up 0.3%mom and accelerating 0.1pp to 1.8%yoy.
The overall positive tone in the December FOMC minutes and the data flow to date continue to underpin the prospect of a near term rate hike, likely as soon as the Fed’s March 22 meeting. Nonetheless the brief US government shutdown (and risk of further disruption) and comments by US Treasury Secretary Steven Mnuchin late in the month weighed on the US dollar for much of January.
This was only reversed partially as financial market dislocation prompted a flight to the US dollar.
h2 Eurozone powers on as UK treads water/h2The upbeat tone in the Eurozone continued late in 2017 supported by ongoing and synchronous global growth. This was particularly evident in the PMI surveys and, despite the December manufacturing read remaining flat at 60.6, due to an upward revision of the previous month this was an all-time high for the series (back to Feb 2015). Similar strength in the services PMI pushed the overall composite index to 58.1 again a high for this series. In January data the PMIs remained elevated around these highs and suggest that there may again be some upside risk to economic growth in the region in early 2018.
Business sentiment indicators also remained elevated and this should continue as the threat of a breakdown in German government coalition talks dissipated. Chancellor
Angela Merkel and Social Democratic Party (SPD) leader Martin Schulz have all but completed formal coalition negotiations that should see the announcement of an
agreed government program in March (SPD members vote on the coalition deal March 4th).
The positive underlying tone again supported Eurozone growth in Q4 with real GDP shown to have expanded 0.6%qoq and this combined with an upward revision to
Q3 saw the annual rate of growth at 2.7%yoy – well above estimates of trend growth. ECB President Mario Draghi noted this month that the economy has “strong and
broad-based growth momentum at the turn of the year.”
However, this momentum has not as yet translated to any sustained acceleration of inflation with decelerated to 1.4%yoy in December with the core measure remaining
at just 0.9%yoy. Draghi also noted that while exchange rate volatility does create some uncertainty that the appreciation of the euro against the US dollar was justified
given the improvement in the outlook.
In the UK, the data were again mixed. PMI data remains solid and this continues to support an underlying rate of real GDP growth that has so far remained at least robust,
expanding 0.5%qoq in Q4 but resulting in a deceleration of growth through the year to 1.5%yoy. Services sectors drove much of the growth in the quarter. The quarterly
rate of growth was slightly ahead of the Bank of England’s expectations foreshadowed in November, and this gives it the confidence to suggest it will raise interest rates “a
few times” over the coming two years. A persistently high rate of inflation, which came in at 3.0%yoy and 2.5%yoy on headline and core measures respectively in December, seems to underpin this stance. As does a surprisingly good read on employment to November with 102,000 jobs added, after the previous two months saw 70,000 jobs lost – this has kept the unemployment rate stable and very low at 4.3% since last July. Despite this labour market tightness there has been no further acceleration of wage growth which remains at 2.5%yoy.
Economic data continues to be relatively solid in Australia, particularly when it comes to labour market performance. Another 34,700 jobs were added in December, prompting employment growth to accelerate yet further to 3.3%yoy. This is the strongest annual rate of growth since 2008 and sees a record 15 consecutive monthly seasonally adjusted increases in employment. Nonetheless the unemployment rate remained ticked slightly higher in the month as the participation rate took another leg upwards to 65.7%. This strong labour market performance is underpinning an uplift in consumer sentiment that is supporting spending.
This is at least in volume terms with real spending rising 0.9%qoq in Q1 and will add materially to GDP growth in the quarter. However in nominal terms the picture is much
weaker with spending volumes clearly supported by heavy discretionary retail discounting.
This is being reflected in CPI inflation, which came in at 0.6%qoq and 1.9%yoy in headline terms for Q4 and ‘core’ measures recorded a modest lift of 0.4%qoq and are up
1.9%yoy. Whilst this was broadly in line with the Reserve Bank of Australia’s (RBA) expectations, another measure of underlying price pressures, the market goods and services excluding volatile items index, was up just 1.1%yoy.
This suggests that price pressure emanating from the economic, rather than administered and seasonal prices, remains very subdued.
Housing indicators continue to demand attention: building approvals remain volatile and a spike in apartments in November will likely retrace in coming months, with the
modest downtrend in overall levels resuming. Housing credit growth continues to decelerate modestly to 6.4%yoy, as investor growth declines slightly outweigh the pick-up in owner occupier credit demand; and dwelling prices continue soften with the capital city aggregate down 0.4%mom in December and annual growth decelerating to 4.3%.
The RBA’s first meeting of the year brought little change to its bias or policy stance. It noted in its post-Board meeting press release that “Further progress in reducing
unemployment and having inflation return to target is expected, although this progress is likely to be gradual.”
This was a sentiment also reflected in the RBA’s Statement on Monetary Policy (SMP) that contained no material change to the Bank’s economic outlook.
RBA Governor Philip Lowe however did seem to add a new aspect to how we should think about the economy, and the timing of the RBA’s first rate hike. He noted in his first key speech of the year that the economy was still “some way from what could be considered full employment and our central scenario for inflation is for it to remain below the midpoint of the medium-term target range for the next couple of years”. When progress towards this objective has been made, Lowe added, then “it will be appropriate for interest rates in Australia to also start moving up”.
This is interesting for two reasons. Firstly, is that the RBA forecasts the much focussed on ‘core’ level of inflation not to reach the bottom of its 2-3%yoy target until late
2019. Further, it does not forecast the unemployment rate below 51⁄4% at any point in its forecast horizon – with full employment at least 5%. In the current context
this could reasonably be judged to be slightly below this mark, particularly given relatively high levels ofunderemployment. As such, the rate of all important wages
growth will not pick up “for some time”. These factors will determine the timing of the hiking cycle – the question will be how much “progress” is required towards these
objectives, in an environment of record low policy rates, to illicit a policy response?
We expect a ‘core’ inflation rate above 2%yoy, unemployment at 5% or slightly below (consistent with other developed economies running below NAIRU unemployment to generate a wage growth response) and wages having to materially pick up. To date adjustments towards these objectives have been painfully slow and on the RBA’s own forecasts may continue to be so.
Consequently, on the current outlook, the first hike in rates from the RBA risks coming in 2019 rather than mid to late 2018 as markets are pricing and a significant number of economists expect.
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