Christophe Bernard joined Vontobel 2012 as Chief Strategist. He is also Chairman of the company’s investment committee.More Articles
With the end of the year approaching, it’s time to dust off the cover of heartwarming stories like “A Christmas Carol” by Charles Dickens. Investors may indeed reach for a special fairytale, hoping that “Goldilocks” will once again lend her name to the development on financial markets in the year ahead. An economy running at just the right pace to avoid both recession and overheating is indeed a distinct possibility in 2018.
Goldilocks may be the only fairytale character that made it into everyday “econspeak”. This 19th century heroine will be remembered for liking her porridge neither too hot nor too cold – a taste that was apparently lost on her companions, the three bears. The girl’s sensible approach in the face of adversity must have impressed some modern-day financial professionals (who, as a rule, prefer bulls to bears, anyway). So, “Goldilocks” has come to mean a tempered economy, not hot enough to cause inflation and not cold enough to cause recession. Such a situation is characterized by a low unemployment rate, increasing asset prices, low interest rates and steady GDP growth. Clearly, 2017 deserves such a qualification. What about 2018?
Since the middle of 2016, the lackluster global economy has entered a virtuous circle, with a broad, synchronized recovery leading to upward revisions of GDP growth projections by the International Monetary Fund and the Organisation for Economic Co-operation and Development, among others. Despite virtually full employment in the U.S., wage growth and core inflation readings have remained subdued. This has allowed the U.S. Federal Reserve and fellow central banks to maintain a loose monetary policy, in aggregate. Even though we expect U.S. core inflation (personal consumption expenditure deflator excluding food and energy prices, the Fed’s preferred inflation measure) to accelerate towards 1.8 percent in the second quarter of 2018 from the current 1.4 percent, we do not foresee the U.S. economy running too “hot” in our central scenario. This means that we expect growth to accelerate slightly to 2.5 percent and the U.S. central bank to raise interest rates only twice over the course of next year. With corporate earnings possibly growing at a double-digit rate in 2018 – and assuming the U.S. tax reform is implemented – stocks should outperform government bonds and credit markets should remain well supported. Alas, absolute valuations do not look attractive at this point, which puts a cap on expected returns (see chart 1). What could derail our central “’Goldilocks’, again” scenario?
Chart 1: High valuations dampen the prospects for U.S. stock market returns
Source: Thomson Reuters Datastream, Vontobel
While we currently see no reason why the global economy should slow down, a combination of adverse events could well do it. First and foremost, the current clampdown of Chinese authorities on investment vehicles that serve to finance the large shadow banking system could trigger a sharper economic slowdown than expected. This would be a headwind to global trade. A botched U.S. tax reform might prompt companies to cut costs and investments while slower equity and real-estate gains – coupled with lackluster wage growth – might hit consumer spending. In Europe, clear gains of the Italian protest party Movimento 5 Stelle in the forthcoming election could see doubts about the euro zone’s future resurface. In such an environment, equity markets would suffer from analysts’ downgrades of corporate earnings estimates. As a consequence, central banks could snap back into crisis mode, possibly prompting a flight to safe-haven government bonds and gold. However, the probability of such a scenario is small, in our opinion.
At a time when even members of the U.S. Federal Reserve are baffled by very subdued inflation, a spike in the consumer price index would be a true surprise. This of course wouldn’t have to be a rise to absurdly high “Weimar Republic” or even 1970s levels, but a likely overshooting of the 2-percent inflation target of most central banks. For this to happen, wage growth would have to break the current 2.4 to 2.8 percent range clearly enough to push the Fed to tighten key rates aggressively in a bid to prevent overheating (see chart 2). Five U.S. hikes in 2018, for example, which would take the federal funds rate to 2.75 percent, would definitely surprise market participants and in all probability send both bonds and equity prices lower. A yield of 2.75 percent would make U.S. dollar cash a formidable competitor to many pricey assets, especially across corporate bond markets.
Chart 2: When hourly wages in the U.S. go up, inflation may not be too far away
Source: Bureau of Labor Statistics, Thomson Reuters Datastream, Vontobel
Looking into 2018, we believe there is a reasonably strong probability that “Goldilocks” conditions will stay with us at least during the first half of the year. This environment is supportive for equity and corporate bond markets. At the same time, the central banks’ – especially the Fed’s – gradual withdrawal of liquidity will probably weigh on “core” government bond returns.
Our portfolio positioning remains virtually unchanged as it’s broadly consistent with our central scenario. Given the elevated valuation of equity and fixed-income markets in absolute terms, we continue to gradually raise our exposure to alternative strategies. These are meant to deliver returns that are uncorrelated to other asset classes. While bull markets do not die of old age, they flatten out with optimism and die on euphoria. Although optimism is now widespread among market participants, it has by no means reached euphoric levels. 2018 looks good, but we shall remain vigilant.