The performance of most asset classes in the year to date has been mixed, to put it euphemistically. Is there a common underlying factor? Can we expect to see a better second half of the year?
Both past development and future outlook of the most important economic indicators are painting a favourable picture for the markets. Real global economic growth is strong, inflation in the developed economies is low, and the monetary policies are supportive.
The common underlying factor for the losses on the markets is the increasing level of uncertainty. Literature generally defines uncertainty as the component of future fluctuations of a factor (e.g. economic growth, inflation, key-lending rate, share price) that defies a modelled forecast. Of course, ongoing and predictable changes also affect asset prices, but they do not constitute uncertainty. For example, an increase in corporate debt is detrimental to spreads, much like an expected decline in company earnings is negative for share prices. A situation of macroeconomic uncertainty is one where uncertainty is rising across numerous areas. This is exactly what seems to have happened this year.
- From trade conflict to trade war? The increase in import duties in the USA and the announcement of additional measures have fuelled fears of escalation. Generally speaking, a trade war leads to lower economic growth and higher inflation.
- From the trust crisis to the government debt crisis in Italy? The minor crisis of trust relating to Italian government bonds in May indicated that, while bail-out funds were available in the Eurozone (ESM, OMT), they would only be applied if Italy wanted that sort of help and if it also accepted the austerity measures that came with said bail-out.
- Currency crises in an increasing number of economies? The appreciation of the US dollar and the rising US dollar interest rates have put pressure on countries with external and internal imbalances, with the Argentinean (peso) and the Turkish (lira) currencies particularly exposed. Among the external imbalances are high current account deficits and high debt in US dollar, while among the internal ones are high inflation and high budget deficits. The risk is that other countries could also come under pressure.
- Restrictive central banks? Economic growth has turned increasingly self-supporting in more and more countries, with inflation gradually converging towards the central bank target. Therefore, central banks can rein in their supportive monetary policies, i.e. raise key-lending rates to neutral levels and terminate or taper asset purchase programmes (“quantitative tightening”, QT). However, the estimates of the neutral interest rate and of the effects of QT are really more an educated guess than a robust estimate. If the neutral interest rate really were lower than assumed by the central bank, this could set off a recession.
- Inflation issues? The Phillips curve is the standard model for estimating future inflation. However, it is difficult to model the relationship between unemployment rate (low) and inflation (equally low). As has happened frequently in the past, inflation could ultimately jump up.
- Recession? There are two crucial differences to the kind of growth we experienced last year: there is no surprising, simultaneous acceleration across numerous countries; and some countries/regions are growing significantly (USA), whereas others are weakening (Eurozone, China). Also, important survey-based global economic indicators have been on the decline for months (e.g. the global purchasing managers index for the manufacturing sector), and the differential between long- and short-term Treasury bonds in the USA has been closing. The risk of a recession has increased in the medium term.
- Insufficient market liquidity? The short-lived slump of the equity markets at the beginning of February and the abrupt rise of Italian government bonds in May illustrated yet again that the liquidity on the market can dry up very easily (with “all” investors wanting to sell at the same time). Small causes can trigger large effects.
Global economic growth is still strong. Given that we have not had a recession in a while (N.B. the USA is currently going through its tenth year of expansion), several uncertainties have increased simultaneously, and a recession has practically never been correctly forecast, spreads have widened on the basis of the deterioration of the environment. On the upside, if uncertainties do not increase further or materialise, a lot of negativity has already been priced in.
Prognoses are no reliable indicator for future performance.