As we move towards the final furlong in 2017 and strategists and economists look at the themes, event risks and potential landmines for 2018, it is always worth reflecting on the year that was and subsequently the platform that has been set for the year ahead.
2017 has been a year where few would have correctly predicted such broad positivity running through global capital markets and to a multi-asset money manager, or any market participant who looks at the big picture and takes discretionary positions based on global macro trends and thematics, it’s hard to believe these moves will be replicated again for many years. With the exception of funds that specifically benefit from high volatility or short exposures, then one could argue it’s almost been a perfect year for global markets.
The biggest issue, of course, is that for the most part no one had any genuine belief that asset values could keep appreciating and few had conviction around owning risk assets, such as equities. What started in early 2017 as the most unloved market rally ever has morphed into one where many, specifically active money managers, have had to overlook valuation and increase risk as their benchmark has moved too far away from their own funds underlying performance.
The perfect year…probably
Had you gone into January believing the USD was going to be down 7% by November, which in part has led to staggering total returns in emerging markets, you would have been shocked, such was the consensus view that the USD was to be the star performer. However, we find the positive flow has resonated across all parts of the capital markets and we can see a 5% gain in high yield credit, while fixed income has provided a positive total return and global equities, notably in China, Hong Kong and US tech has had some huge moves. Pullbacks have been almost non-existent, especially in the US, where we have just witnessed a 51 day stretch without 0.5% drop in the S&P 500 – the longest run without a 50bp drawdown since 1968!
The factors behind these moves have partly been a legacy issue from years of exceptionally loose monetary policy. However, we can also see 2017 heralding highly predictable central bank policy and forward guidance, which has largely help ring-fence any geo-political and political concern. For perspective, the ECB are still buying six times the amount of government debt that European governments are issuing, while the Bank of Japan now own the majority of the Japanese ETF market and could almost be labelled the world’s biggest hedge fund!
But then you add in strong corporate earnings growth (and not just through buy-backs), and global growth running close to 4%, with over 75% of countries globally seeing above trend GDP. All the while inflation in G10 economies, on the whole, is running below the central banks mandated policy targets and these institutions have no urgency to hike rates and the moves in interest rates have been more a reflection of increasing concerns around asset values and growing financial risks from years of zero and negative interest rate policy and balance sheet expansion (quantitative easing).
Perhaps the biggest driver of all, after aggregating all these inspirational factors, has been the impact this has had on smashing realised and implied volatility, in all asset classes, except perhaps the crypto space. With such low volatility allowing hedge funds and asset managers to take even more risk and increased exposures to equities. It’s no wonder reported wealth manager’s weightings to cash (in diversified portfolios) sits at all-time lows, while NYSE margin debt (i.e. borrowed funds) is at all-time highs.
So with the year that was and the dynamics laid out above we roll into 2018 trying to decipher if these macro-economic thematics alter to any great degree, or if they continue in earnest. So while one can try and make predications and prophesies say where the USD or various equity or commodity markets could be heading this coming year, I feel the best way to think about 2018 is through the lens of what will be the overarching thematics and from here work out which is the best asset class or market by which to express this view.
Three key theme’s that could be in play in 2018
‘The smooth transition’ – this would really be an extension of 2017 and what originated from 2009 as purely artificial financial markets continue to resemble more ‘normal’ conditions, with sustained earnings growth (not just corporate buy-backs) and stronger nominal global economic growth, backed by animal spirits and business investment. The end result; ‘good’ inflation that erodes elevated debt levels, allowing central banks further scope to gradually tighten policy and to focus on financial risk and frothy asset levels.
The potential market reaction – implied volatility remains low, equities and commodities outperform, bond yield curves steepen. Probability (my best guess) – 45%
‘The stealth inflation shock’ - DM economies see the very thing central banks have been trying to engineer for years; inflation. However, it comes when the markets are not expecting it, in turn, exposing central banks to be grossly behind the curve, with ‘real’ bond yields moving sharply higher, causing a tightening of financial conditions. In this scenario, volatility spikes higher and funds increase cash weightings, with risk assets (such as equities) falling sharply before adjusting.
Market reaction – the US volatility index (or the “VIX”) spikes to 18% and above, global equities decline 10-20%, and emerging markets and countries where household debt is exceptional high (such as Australia) see strong capital outflows (AUD/USD much lower). Probability – 35%
The ‘Black Swan’ event – we get an event or series of major events that are not yet known and that markets are not prepared for. This results in a deflationary shock through both DM and EM economies, which causes central banks to reassess their monetary policy settings. The obvious question then one has to ask is what have central banks (and governments) got to stop a genuine a deflation cycle event this time around? Very little one could argue.
Market reaction – The “CBOE Volatility Index” spikes above 30%, government bonds rally strongly and we see increased signs of inversion in yield curves, while CHF, JPY, gold and Bitcoin all rally hard. Probability – 20%
Of course, there are many other scenarios we could be facing in 2018 and while this is a fairly simplistic way of looking at the world, I think the ability to have an open mind and react to the ever changing dynamic will absolutely help drive profitability. Holding onto a view and not adapting or being able to admit you may be incorrect in your judgment, as we have seen through 2017, is one sure way to lose capital.
Views, criticisms and thoughts always welcomed.