This article is the first of a two-part look at the themes now challenging the Goldilocks narrative: signs of diverging growth, a stronger US dollar and risks of a broadening trade war. We believe these “three bears” are likely to make for a much more challenging environment for risk assets. In the meantime, markets remain fragile and susceptible to heightened volatility.
As 2018 began, the consensus market narrative was centred around a Goldilocks scenario characterised by synchronised strong global growth and modest inflation pressures. This backdrop, combined with still-accommodative monetary policy in developed markets, was expected to support the continued solid performance of risk assets.
As we discussed in our second-quarter outlook, we were then in the throes of a test of this narrative. Strong US inflation 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 and the adjustment to a steeper expected policy rate path has been relatively smooth.
Back to Goldilocks after the volatility spike?
One could have expected a swift return to the Goldilocks narrative. However, three events seem to have put the basic assumptions of this long-standing thesis to the test.
- First, global trade frictions 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 US’s 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 the Goldilocks challenges, economic data pointed to stronger GDP growth in the US than in Europe, China and the rest of Asia. This shattered the market belief in synchronised global strength.
Knock, knock, we are the three bears
In sum, “three bears” emerged – new signs of growth divergence across major regions, a stronger US dollar and increasing risks of US protectionism.
- Taking these in turn, strong growth momentum across major economies has come under scrutiny and 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, a softening that has now begun to shine through to the hard data. Japan has also had a loss of momentum, as have some large emerging market economies. And in China, official efforts to rein in debt in the state enterprise and local government sectors have slowed 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 under-pricing the Federal Open Market Committee’s resolve to move gradually towards a restrictive policy stance in 2019. If US protectionism fears fade and inflation continues to firm, the 10-year Treasury yield could easily move back to above 3% quite rapidly. It is the speed of such a change that would impact risk assets. As we have already 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.
- The US dollar (USD) has reversed relative to the euro, sterling and many emerging market (EM) currencies. To be sure, the 2017 call for a weaker dollar always seemed questionable given that the Federal Reserve was well ahead of the rest of developed market central banks in removing both traditional and quantitative easing measures. Despite this, the broad consensus was that an ageing US economic cycle and long-term debt sustainability issues would lead to a structural decline in the US dollar. Now, higher short-term US rates have transformed the US dollar from a funding currency to a carry trade, leading to a resurgence of dollar strength. The short position in the USD reversed at the beginning of the second quarter when growth divergence began to take shape. As the US economy continues to strengthen in relation to others, investors continue to cover dollar shorts.
- US trade policy is generating increasing tensions with major trade partners. We have never doubted the Trump administration’s desire to revitalise the US manufacturing base and reduce bilateral trade deficits, using tariffs as a form of negotiating leverage, but also as a means for achieving these goals if necessary. We have also appreciated the resolve of other nations to safeguard international rules and norms that support free trade as well as the political necessity of retaliating against US tariffs.
Trade policy – is the bite as bad as the… growl?
Unfortunately, trade tensions will likely only escalate in the months ahead since all sides believe they have the upper hand in negotiations. Most notably, the US believes that the sheer size of bilateral goods deficits with the EU and China, as well as the greater importance of exports as a growth engine for those economies, provide significant leverage. Strong US growth and Trump’s high level of support among Republicans also underlie the administration’s strategy of demonstrating a willingness to incur short-term costs in trade fights. There may be some logic to this thinking, but as the administration is fighting on numerous fronts at the same time, it is likely overplaying its hand.
Exhibit 1: Would more trade or less trade with other countries be better for the US economy?
Source: University of Michigan survey of consumers, as of 29 June 2018
When it comes to specific trade clashes, it is challenging to see a clear path to resolution any time soon. Issues regarding China’s intellectual property practices will prove difficult to resolve to both parties’ satisfaction. China has a strong incentive to insist on foreign technology transfer as part of the “Made in China 2025” strategy that aims to transform China’s high-tech, high value-add industries into global leaders. Meanwhile, the US increasingly sees this as a long-term strategic threat and is unlikely to give in.
As to NAFTA, a unified negotiating position between Mexico and Canada will make it hard for the US to make headway on its demands for higher North American content and a sunset clause, increasing the chances that the administration will signal its intent to withdraw from the agreement to gain leverage in negotiations. Finally, the administration’s newfound focus on trade in cars could prove equally challenging to resolve. At the very least, we doubt the US will be willing to drop its high tariffs on truck imports – a likely demand from the EU.
In addition, businesses may abstract from the implementation of US tariffs against China that tariffs against other nations, along with retaliation, are increasingly likely. This may lead to a fall in business confidence that delays hiring and investment decisions and will ultimately weigh on economic growth. Increasing risks of a broader trade war will also impact the stock market, further weighing on household and business spending. A full-scale trade war, characterised by high tariff barriers and an unravelling of global supply chains, may well be avoided. But if businesses and households simply assign a higher probability to this outcome, it could still have a deleterious effect on the global economy.
In the second part of this article, we will look at the emergence of a ‘fourth bear’ in Goldilock’s world – and at the implications of all four bears for a variety of fixed income asset classes.
*The full version of this two-part article first appeared in Fixed income quarterly outlook – Q3 2018 from BNP Paribas Asset Management (12 July 2018)
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