A ‘fragile goldilocks’ environment, where growth is soft, but not recessionary, and where monetary policy is supportive due to low inflation, neatly describes the backdrop seen so far in 2019, with bonds and equities posting strong gains.
Where do we go from here?
We see two likely scenarios: a move to a reflationary environment or a move to a recession.
At the end of August, with trade war rhetoric ratcheting higher and some macroeconomic data deteriorating further, it felt like the slowdown scenario was gaining traction.
However, apart from the recent mini oil shock after fears of lost Saudi Arabian crude output, we now see three themes that need monitoring for a move to a more reflationary world:
- Supply shocks & de-globalisation
- Fiscal stimulus
- Economic recovery & China easing
A reflationary shock would represent a significant shift in the outlook, one markets have not been used to in recent decades, and crucially, one markets are not priced for given their reliance on monetary policy after the Great Financial Crisis.
De-globalisation a supply shock
We believe the trade tensions between China and the US are part of a wider de-globalisation trend that includes political rifts such as Brexit and the populist outcry in Europe. De-globalisation is unlikely to stop any time soon, making it a significant source of uncertainty.
This is already hurting global growth. The manufacturing sector has been at the epicentre of this process.
The slowdown in trade and business investment is part of the same de-globalisation force. This hits demand and supply. These tensions involve dismantling or at least re-directing, the way goods and services are being produced in major economies, from China and the US to the UK and Europe.
Persistent supply shocks can lead to lower trend growth. If growth is hurt materially, the pressure of aggregate demand on now weaker supply could be greater than anticipated. Such shocks can lead to greater inflationary pressures than previously envisaged.
Fiscal stimulus around the corner?
More expansionary fiscal policy could also fuel reflation.
The ECB has done a lot to support the economy, but President Mario Draghi has made it clear that the limits of monetary policy have been reached. Further fiscal stimulus is also a possibility in the US, where President Trump will try to keep the economy in good health as he campaigns for re-election.
Interestingly, fixed income markets have not reacted to this shift. This could reflect scepticism about the ability of the authorities in large economies to embark on a material fiscal expansion. It could also reflect the fact that as the global economy slows, market participants and economic agents continue to expect central bank easing to be the first line of defence and it will take time for markets to shift away from this view.
Economic recovery and Chinese easing
The third route is more “traditional” – economic expansion. US domestic data has remained strong – a point reiterated by FOMC chair Powell at the latest Federal Reserve meeting. The Fed still sees its recent policy rate cuts as a mid-cycle adjustment (‘insurance cuts’) because of external risks rather than domestic worries.
In China, monetary easing has historically translated into economic upswings in large trading partners. Indeed, its efforts appear to have resulted in at least some stabilisation in, for example, Germany.
Risks in fixed income more skewed than in equities
Admittedly, none of these developments is necessarily imminent and their time horizons could differ significantly. Equally, financial markets are unlikely to wait for absolute confirmation. They typically anticipate developments even before they fully materialise.
However, markets have become so used to monetary policy as the ‘only game in town’ that they are not priced for reflation – the fixed income market especially so. The strong year-to-date returns are a symptom of (looser) monetary policy being priced in.
From a valuation perspective – in Exhibit 1, we compare real yields and CAPE metrics to their long-term averages since 1990 – bond markets stand out across regions as being expensive.
Exhibit 1: Equity versus bond valuations – fixed income looks vulnerable
CAPE: cyclically adjusted price-to-earnings ratio; source: Bloomberg and BNPP AM, as of 30/09/2019
Put differently, with subdued inflation now the norm, the ‘lower-for-longer’ dynamic prevails and fixed income markets are biased in terms of expecting more of the same. As such, a shift to fiscal expansion, let alone more radical alternatives or other reflationary environments, would be a huge game changer.