As 2018 began, the consensus market narrative was centered around a Goldilocks scenario characterized by synchronized strong global growth and modest inflation pressures. This macro backdrop, combined with still-accommodative monetary policy in developed markets, was expected to support continued solid performance of risk assets. As we discussed in our second quarter outlook, we were then in the throws of a test against this market narrative. Strong US inflation prints led to a recalibration of monetary policy expectations as the second quarter began. This resulted in a spike in bond yields that ultimately weighed on global equity performance. As equity volatility rose, quantitative trading strategies were forced to cover short volatility positions across markets. This set off a negative feedback loop that led to further spikes in volatility measures, and served to exacerbate the downturn in equities and other risk assets. Despite a tumultuous opening to the second quarter, the dust settled on the event, and the adjustment to a steeper expected policy rate path has been relatively smooth.
One could have expected a swift return to the Goldilocks narrative after this event. However, three events seem to have put the basic assumptions of this long standing thesis to the test. First, global trade frictions have increased as threats of tariffs from Washington were met with defiant responses as the Trump administration alienated supposed trade rivals, as well as some of the United States’ closest allies. This ignited a concern that there could be a re-calibration of global growth and corporate earnings forecasts. The sell-off in equity and spread products returned, this time with greater breadth as asset classes and industries that survived the volatility event (for example, emerging market debt) saw interest and liquidity begin to evaporate. To add to Goldilock’s challenges, economic data released during the back half of the second quarter pointed to stronger US growth vs. weaker growth in Europe, China and the rest of Asia. This shattered the market belief in synchronized global strength.
In sum, “three bears” have emerged to chip away at the Goldilocks narrative – new signs of growth divergence across major regions, a stronger dollar, and increasing risks of US protectionism. Taking these in turn, strong growth momentum across major economies has indeed come under scrutiny and had been found wanting. The Eurozone, which had perhaps been the lead character in the growth acceleration story of 2017, has experienced a significant softening in activity indicators which has now begun to shine through to the hard data. Japan has also experienced a loss of momentum, as have some large emerging market economies. And in China, official efforts to rein in leverage in the state enterprise and local government sectors have led to a slowing of activity, prompting the central bank to cut reserve requirements in a targeted effort to support smaller enterprises.
Resilience in the US economy may be encouraging while growth disappointments emerge elsewhere, but that resilience also contains risks. For markets, a “tightening tantrum” similar to the first quarter yield spike could easily be repeated. Markets are still underpricing the Federal Open Market Committee’s (FOMC) resolve to move gradually towards a restrictive policy stance next year. If US protectionism fears fade and inflation continues to firm, the 10-year Treasury yield could easily move back above three percent quite rapidly. It is the speed of such a change that would certainly impact risk assets yet again. As we have learned far too many times, it is the slope of change rather than the terminal rate that matters the most when it comes to the pricing of credit and other risk premium spread products.Download to read more