Last year, I worried we could see markets come down to earth with a bump. Rising populism would be chief among the potential triggers for such a correction. Yet here we are. Equity markets are reaching new heights, credit spreads are at cycle tights and volatility is near an all-time low.
The key variable I got wrong was liquidity. I overestimated the impact of Fed monetary tightening relative to global easy liquidity conditions. My assumption was that this could lead to a stronger dollar, reflecting tighter financial conditions. It would then put pressure on the global carry trade that has propped up asset valuations.
Despite a strong year for risk assets, we have not yet seen the solution to the structural problems holding back productivity and growth. Deteriorating demographic trends seem set in stone. Debt continues to accumulate, suggesting a large misallocation of capital.
In recent years, central bank purchases have crowded out investors. I see this dynamic reversing in 2018
Calling the top in a bull market is very hard. With continued loosening in financial conditions, global growth has been strong, corporate profits buoyant and inflation subdued. This has allowed central banks to remain cautious in removing their extraordinary support. But I’d say this is the consensus narrative for 2018. It dominates every year-ahead outlook that has hit my desk in the last few weeks, suggesting that markets are priced for another Goldilocks year.
For me, the game-changer in 2018 is liquidity. The main driver of asset prices since the global financial crisis has been the trillions of dollars of liquidity created by central banks. China’s spending spree accompanied this, taking debt/GDP from 141% in 2008 to 258% today. 2018 could be the year that this radically changes.
Net of redemptions and quantitative easing (QE), government bond supply is set to soar in 2018.
The chart above shows what is happening to the supply of government bonds. In recent years, central bank purchases have crowded out investors, forcing them to choose between zero-yielding deposits or much riskier investments. I see this dynamic reversing in 2018. We could see the ‘hunt for yield’ trade that has supported credit markets in recent years start to fade.
China is looking to tighten regulations for the shadow banking sector. Having created $9 trillion of debt over the last two years, and with a $15 trillion asset management industry, policymakers will have to be very careful when applying the brakes. Even if they avoid any mis-calibrations, a more cautious approach from the world’s biggest debt creator should cause global liquidity to suffer.
If the liquidity narrative reverses, we could be in for a rude awakening
This is not to say my populism concern from 2017 has disappeared. Seismic political shifts have occurred over the last two years. But the markets have been comforted by the warm blanket of QE. With liquidity going in reverse I expect political risk premium to re-emerge.
The start of 2018 will be caught between two narratives: globally synchronised growth versus tightening global liquidity. A typical economic cycle lens suggests 12-24 months left of this cycle, but to me global liquidity and credit creation is an underestimated factor. Low volatility and high asset prices breed complacency. Of course, this could continue a while longer. But if I’m right and the liquidity narrative reverses, we’re in for a rude awakening. Given elevated valuations, a 20-30% correction for global equity markets is possible.
What does this mean for our multi-asset portfolios?
As Anton outlined, timing any pullbacks are very tough to predict; but timing is crucial for our client's outcomes given the potential for strong returns prior to corrections. As a macro investment team, we spend a lot of resources analysing market risks and mapping them into our asset allocation. Anton and other macro thinkers in LGIM are important and valuable sources to help us map out these risks.
Going into the New Year we are tactically cautious on equities but not extremely so; that will evolve over the year as the team and LGIM more broadly identify emerging threats and potential triggers for corrections. The risks of a correction will materially increase when the economy goes late cycle.