We received this punchy 2018 outlook rundown from Stray Reflections via KVP from Saxo Markets. We are not terribly huge fans of 'outlook pieces' but do recognize the value in the intellectual process of thinking and codifying one's thoughts. Jawad Mian's great framing of the big issues in the year-ahead inspired us to jot down a few of our thoughts (as short comments). Our comments in italics. Underlined = our emphasis.
Politics
- The political climate in Washington will turn even more toxic in 2018, as Trump/Bannon take aim at the GOP establishment, the saga from Mueller’s Russian inquiry rolls on, and we likely see a reopening of the Clinton email investigation. The political maelstrom may have many broad consequences. Agree that the upcoming (high-stakes) midterm elections will incentivize even more mudslinging next year. However, Trump's political capital has waned and what little he has left could be squandered if he/Bannon take on the GOP. I would go further to say that alienating moderate GOP members could backfire: 1/ Trump will alienate moderate GOP voters. 2/ It won't win friends among the GOP congressmen if/as the Mueller investigations lead to more incriminating evidence and eventually grounds for VP Pence to replace him. 3/ If Trump is secure through 2018, it will be because he has been a 'lame duck' president with very little relevance - or ownership - over the agenda.
- For the midterms, it is our expectation that President Trump, and those allied with him, will not only defeat the Democrats (especially in the ten “blue states” which Trump won), but also Republicans, giving him full control of the House and Senate. The GOP establishment is losing control of the Republican Party.
I beg to differ here. I believe the GOP establishment will strike back and they will get their opportunity as it becomes apparent that Trump is proving to be more of a liability for the party (see comments above).
- What happens to the renewed EU integration drive if during the next twelve months, Chancellor Merkel loses power, Theresa May is replaced as the UK leader, the 31-year old Luigi Di Maio of Italy’s populist Five Star Movement wins the national election, and Macron, with falling poll numbers, emerges as the sole leader with a lofty vision for Europe?
Agree that the EU integration drive is at risk. I am not sure if the EU leadership (via a weakened Merkel/Macron) has the bandwidth/drive to deal with visionary EU 'project-building' efforts (this will take a backseat) at the same time as post-Brexit trade is being negotiated, idiosyncratic member-level issues crop up (besides Italian election, adding Spain here) and as other countries seek to re-define its relationship with Brussels (eg Poland and Hungary). Integration efforts are likely to focus on lower-hanging fruit such as regulatory harmonization (eg wrt financial oversight).
- Xi Jingping has succeeded in getting an unprecedented number of his allies on the Politburo. As per his “Socialist Modernization” project, China will continue to assert its regional influence and to seek equality with the US globally backed up by increasing military power.
- North Korea’s brinksmanship with the US will remain elevated after multiple rounds of start-stop diplomacy, increased US-China tension, and potentially worsening behavior by Pyongyang in order to prove that the US economic pressure campaign is ineffective and counterproductive. I'm a bit more hopeful here. That Pyongyang is closer to the end of its nuclear program could be a positive catalyst for talks. Insofar as the US does not take the lead in negotiations (watch for a pivotal role by the ROK), the DPRK may see itself as ready to be re-integrated economically. But first, the five regional powers have to accept a nuclearized North Korea (watch Japan here).
Policy
- The Fed’s leadership change is a major story for next year. Although we don’t expect the general thrust of monetary policy to change radically, history suggests that markets will “test” Jerome Powell early in his term. The median correction in US stocks is 10% in the first six months of a new Fed chair.
This US stocks observation is interesting in light of the fact that Jerome Powell was chosen as a continuity Fed Chair. Fed policy reaction function, in my view, will likely stay the same - that is to maintain a gradual hike path premised on the (nearly blind-faith) belief in the Philips Curve. The Fed is unlikely to surprise more aggressive than is priced by the market. There will be more hawks on the FOMC next year, but I think many hawks will get cold feet as/when the US Treasury curve flattens further, which provides an opportunity for consensus-builder Powell to swing the committee more dovish (2 hikes more likely than the 3 seen by economist surveys). An SPX correction could flatten the rate hike path further.
- Whereas cumulative global central bank balance sheets will continue to increase for another year, net purchases by the big five central banks will shrink by about $1 trillion in 2018. A coordinated QE exit across central banks should lead to a re-pricing and normalization in risk premia, as the rate of change becomes negative in terms of liquidity expansion turning into liquidity contraction.
- As President Trump’s domestic policy has fallen short of campaign promises, trade protectionism will likely emerge as a genuine global market risk in 2018. Trump faces few constraints on trade which is at the center of his “America First” approach, and so once tax legislation is dealt with with greater trade conflicts loom, not only within NAFTA but also with China and others.
Agree that mercantilist policies will emerge. Trade friction may not just originate from the US but elsewhere (eg EU vs US).
- China’s policy tightening to curb financial excesses poses a near-term risk as the economy has added an enormous amount of leverage in recent years. Stricter financial regulations, crackdown on shadow banking, restrictions on local government borrowing, and property tightening will impact home sales and industrial output. The Chinese government has the capital resources to forestall a debt crisis.
Deleveraging efforts are a laudable - yet eleventh-hour - means to improve medium-term growth sustainability at the cost of short-term growth stability. Authorities are likely to continue with this policy tightening shift insofar as it doesn't induce a market or economic crisis. The property market is a risk to the real economy but controlled supply coupled with localized purchase restrictions are stabilizing prices, though fixed asset investment will take a hit.
Economy
- The common perception is the synchronized upswing in economic activity should remain in place for the next 12 months. Global GDP growth forecasts are being revised upwards. The reality is economic momentum will slow next year. An environment of decelerating growth and tighter liquidity is not ideal for risk assets. The prospect of 'synchronized global growth' conditions flipping to a synchronized slowdown is one of my biggest market concerns. With coordinated global policy tightening underway (save Japan), whispers of globalized policy mistakes should keep the pace of tightening on the more gradual side of consensus views. As economic momentum slows, policymakers may search for growth (and reflation) elsewhere, eg trade policy, weak currencies and fiscal stimulus.
- Curve flattening has previously been an indicator that an economic expansion is getting long in the tooth, but it is worth remembering that the yield curve can flatten for years without tipping into inversion or leading to a recession. We believe recession risks are minimal.
Agree. The most meaningful impact of a flatter UST curve, in my view, will be on the policy side. The prospect of a coming recession (even if more of a 2020 issue) would force the Fed on a shallower rate hike path ('cold feet').
- Although the US economy will remain supported by a number of positive growth drivers, we may be close to the cycle highs for the ISM index. Periods when the ISM is in the highest quartile relative to history and valuations are above average tend to be followed by lower equity returns. The max drawdown in equities after an ISM peak is about 10% on a 6-month horizon.
- Inflation could be the biggest upside surprise in 2018, but from Q2 onwards. The labor market is tightening and wage growth should accelerate at this stage of the employment cycle. Increases in labor costs in excess of productivity gains should put upward pressure on prices.
- We expect Chinese growth momentum to slow from the current above-trend pace as Beijing pares back stimulus efforts. China will also feel headwinds from a stronger trade-weighted CNY and more PMI weakness is likely in coming months.
Authorities are aware of slowing momentum and will re-emphasize quality over quantity of growth rate when it potentially communicates a GDP growth range of 6-6.5% in Mar-18 (down from 'around 6.5%' in 2017).
Markets
- Although we believe the secular bull market is alive and well, it seems investors should be on guard for a more volatile and disruptive phase ahead at this point in the investment cycle. We are bearish on global equities on a tactical horizon (next 3 to 6 months), as earnings growth estimates are too optimistic and multiples should come down in response to the great monetary unwind. A healthy 6-10% pullback is in the cards.
We share a similar view on heightened volatility in coming months and position by buying VIX when it hits a 1mth low.
- Absent sustained inflation, a definitive turn in long-dated Treasuries is not yet evident. In fact, we see the US 10-year yield trading sideways or even lower, below 2%, in the coming months. Credit spreads are historically tight and junk bond yield spreads bottomed in October and are rising. We see 10yr USTs at a wide 2.00-2.60% range in 2018 - driven by degree of economic surprises (in particular NFP and CPI). Upside surprises will outnumber downside surprises in early 1H18 until this reverses around mid-2018. Fed policy and US domestic political dynamics present downside risks.
- The recent US dollar rebound should continue for a while longer as short positioning remains elevated. A consolidation phase for the euro is likely given the political morass in Europe, while the yen is cheap and attractive. EM currencies are at risk if trade comes into focus in 2018, as we expect. Commodities, and base metals specifically, should weaken as China’s industrial economy and housing market downshift. Oil prices have more medium-term upside as shale output disappoints.
Agree with a strategic USD bullish bias through 1H18. This has negative implications for EUR, commodity currencies (AUD, CAD) and EM FX (including the RMB which may move back to a trade-weighted depreciation bias as domestic growth slows). JPY weakness may lag unless the BOJ expands QE purchases in spite of growing criticism over market distortions. The main risk to this bullish USD view is a strong EUR, particularly if Eurozone data goes from strength to strength and this spurs ECB hawks to call for ending QE more more quickly.
- Favoring non-US markets, momentum, growth over value, and cyclical over defensive stocks has been a winning strategy. Prepare for a temporary reversal in all of these trends. We recommend de-risking portfolios and shifting to a more defensive posture. Active management will beat passive but hedge funds won’t shine, as they are broadly positioned with market consensus. This is a time to bet against crowded trades.
Agree with generally defensive positioning. We typically trade based on tactical event/catalyst-related opportunities, but for strategic allocations we like RV trades based on fundamental trajectory (improving fundamental rationale), valuations (lagged performance, cheap PE) and technicals (positioning not crowded). Currently we like Kospi vs Taiex, Ibex vs MIB, Qatar vs Russia, PLN and CZK vs EUR and HUF, Cyber-security HACK vs US Tech IYW.