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November’s leading indicators show a fresh short-term
acceleration in the world economy beyond the 4%
mark. This growth pace is well above potential (3.5%) and
should lead to renewed inflation and validate the
tougher stance on monetary policy across most
developed markets. The economists’ consensus is for a
gradual normalization in yield curves in the G7 under the
cautious leadership of central banks. Against this
backdrop, our asset allocation remains resolutely
offensive, but includes some selective plays reflecting the
highest risks (overvalued markets) and our doubts on the
likelihood of a soft landing for global monetary expansion.
It is worth remembering that the strong and synchronized
growth we are witnessing worldwide is the result of a
successful adjustment by emerging markets after large
devaluations in 2014-2015 (external adjustment, then
disinflation and interest rate cuts, recovery in consumer
spending), Chinese banking stimulus in 2015, reasonable
oil prices (US shale) and lastly, monetary abundance from
Europe and Japan, which is spilling over into the rest of
the world via capital outflows by their institutional
investors. Yellen’s Fed has admittedly implemented some
faint-hearted monetary tightening, but capital inflows
have fueled euphoria on US asset markets (equities, High
Yield credit, real estate) to the extent that this has
cancelled out the effects of key rate hikes on financial
conditions. The strength of the global recovery
automatically means a turnaround in all these factors.
The emergence of bubbles (real estate, bonds), which
threaten social stability, has already forced China to put
the brakes on bank liquidity.
The consequences of this
shockwave have rippled out across the entire Pacific Ring
of Fire as we expected, with a contraction in the building
sector in China, a decline in commodities prices (coal, iron
ore, industrial metals), a shift in real estate bubbles in
Australia, New Zealand, Canada and the US West coast,
and a hit on exports in Peru and Chile. A number of large
emergings that seemed to be dragging themselves out of
their rut in 2017 could be hit by another recessionary
shock due to the drop in commodities prices (Brazil,
Indonesia, South Africa). Oil will also act as a recessionary
factor for developed countries in 2018 if prices remain
above $60 as OPEC hopes.
Lastly, excessive monetary stimulus is almost spent out in
Europe and Japan. In the euro area, the ECB is coming
close to the issue share limits it set itself to avoid accusations of monetization of public debt. Tapering of the
PSPP should come to an end in late 2018 in our view. In
Japan, the BoJ’s monetary artillery (qualitative and
quantitative easing, negative interest rates and yield curve
control) is running up against technical limitations (dryingup
of JGB liquidity, lack of equity ETF), the virtual
insolvency of regional banks (flat yield curve), the risk of
bubbles (commercial real estate) and the likely return to
positive core inflation. We expect the 10-year yield target
to be raised from 0 to 0.15% in 1H, once US tax reform
has been ratified. This will involve a fresh slowdown in JGB
purchases by the issuing institution. Synchronized
tapering by both the BoJ and the ECB should resteepen
the yield curves in the euro area and Japan, with a knockon
effect for the US 10-year yield, as the G3 bond markets
are inter-connected.
In the US, the stimulus provided by tax reform is set to be
drowned out by a rise in inflation, a soaring trade deficit,
rate hikes from the Fed and the surge in the dollar. The
rise in long-term rates triggered by tapering in Japan and
Europe will dent valuations for both equities and real
estate. The shock on long-term rates should only be
temporary as domestic long-term investors (insurers and
pension funds) have already changed their marginal
inflows away from equities and into bonds (equity
weighting target reached as a result of market rally), and
the increase in mortgage rates will soon dry up the source
of fixed-rate MBS issues. The combination of high rates
and rising budget deficit will particularly accentuate the
shortage of dollar-denominated liquidity across the rest of
the world, which is already dented by Basel III, with the
risk of triggering a short squeeze on emerging markets’
external debt. This US policy mix profile harks back to the
Reagan/Volcker era, after which the Third World debt crisis
followed hot on the heels.
We maintain our overweight stance on risky assets via
equities in the euro area, Japan and emerging Asia, along
with European credit (IG and HY) and European peripheral
debt, but maintain our underweight position on assets
exposed to Chinese real estate risk and the dollar’s rise
(emerging debt, Latin-American equities, industrial
metals).
Our currency positions (long USD vs. EUR, CHF,
AUD) are a telling reflection of our view of a world where
the dollar’s exchange rate has superseded the VIX as the
synthetic risk aversion indicator.
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