Canberra Times

Print this article | Close this window

It may not feel like it, but markets have had a great escape

Tracey McNaughton

Published: February 9 2018 - 4:10PM

It has certainly been a stomach-churning ride in financial markets recently.

Equity prices down, bond yields up. Volatility has returned with a bang. Welcome to “The Great Escape”.

For much of the past decade, financial markets have been hostage to unconventional monetary policy - a situation where market liquidity has been supported by the bond-buying behaviour of the biggest central banks in the world.

The result of this has been a suppression of real interest rates, an absence of volatility, and a build-up of crowded, highly correlated, investment positions.

Quantitative easing is now in retreat. Central banks are no longer an overbearing participant in the market.

The US Federal Reserve is in the process of putting back into the market the bonds it previously bought. The European Central Bank (ECB) is reducing the amount of bonds it purchases each month and is likely to end bond buying entirely by September. Speculation is mounting that the Bank of Japan is not that far behind the ECB.

While it may not feel like it right now, this is a good outcome for investors.

Volatility is back and correlations have declined. This means the benefits of diversification between bonds, credit and equities, once smothered by the blanket of central bank activity, have returned.

Financial markets and the economic fundamentals that underpin them have been liberated.

When the dust does finally settle, and clearer heads prevail, there will be opportunities for equity investors in 2018.

Nothing that has happened in the past couple of weeks has served to change the soundness of the underlying fundamentals. This was a market correction, not an economic one.

The global economy is experiencing a synchronised recovery for the first time in a decade. All 45 countries tracked by the Organisation for Economic Co-operation are expected to post positive economic growth for the most recent year.

Labour markets are the tightest they have been in decades. In Japan, labour shortages have hit a 40-year high. In Europe, the unemployment rate has fallen non-stop for the past 4½ years. In the UK, it is at a 42-year low. In the US, the unemployment rate is within earshot of its lowest level since the late 1960s.

Wages pressure, the spark that ignited the recent volatility, is slowly stirring and this will serve to support consumer spending, the single largest component of any economy, going forward.

Crucially, the psychological scarring from the global financial crisis that left corporates bereft of animal spirits is healing. Business investment is growing once again.

This is important because it will support productivity growth and therefore keep excessive inflation pressure in check. This will allow central banks to tighten monetary policy gradually while still remaining on the accommodative side of neutral this year.

For equity investors, the outlook remains very supportive, driven by the combination of strong cash flow, rising margins and healthy balance sheets.

US corporates in particular will benefit from the recent tax reform. This will provide fresh support for equities from higher distributions to shareholders.

The current backdrop suggests strongly that special dividends, share buybacks and earnings-enhancing merger and acquisition activity are likely to increase this year.

Similarly, corporates in Europe (ex UK) and Japan have, in aggregate, spent the post-financial crisis period restoring balance sheet health. Both will continue to be supported by very accommodative monetary policy and a shift towards a more expansionary stance in fiscal policy.

Overall, we expect equity returns in 2018 to be broadly in line with earnings growth. That is, returns are likely to be above average but below those achieved in 2017.

There are three main risks to this outlook. First, a faster than expected slowdown in China. At the moment growth momentum is easing in China but at a steady pace. The concern is the rate at which the Chinese authorities are announcing deleveraging reforms. This may tighten financial conditions and raise funding costs.

Second, the stagflationary threat from a rise in trade protectionism. While US President Donald Trump has imposed steep tariffs on goods such as imported solar panels and washing machines, we don’t believe it marks the start of a trade war. So far, the measures taken have a bigger headline impact than an economic one and are not hugely out of line with steps taken by previous presidents.

A third risk is higher than expected US inflation, leading to a more rapid rise in interest rates. This is a risk that bears watching, particularly if further growth in Europe and Japan causes the US dollar to resume its downward trend.

If this truly is “the great escape”, then the growth potential of the global economy should pick up in line with higher business investment. This implies higher economic growth, higher productivity and inflation in check.

Together with corporate balance sheet health and earnings growth potential, we see this as a positive environment for equity investors in 2018.

Tracey McNaughton is head of investment strategy at UBS Asset Management.

This story was found at: