In his new book, psychologist Steven Pinker details how the human condition has steadily improved over the past millennia. His data suggests that we enjoy longer, healthier and happier lives than our ancestors; that we have made significant progress against disease and starvation; and we have experienced a steady decline in deaths resulting from wars, natural disasters and crime. Nonetheless, despite the mounting evidence, Pinker is forced to ask, “If things are so much better, why do they feel, for so many people so much worse?”
In looking at the market, we take a cue from Pinker and similarly ask, why despite signs of global economic growth do so many feel uneasy about the market?
In hindsight, the first quarter marked a turning point in markets. At the end of 2017, the focus was on the positive impact of well-discounted tax reform legislation in the United States and synchronized global growth. The enactment of the Trump tax legislation produced a short-term top in global equity markets. The euphoria persisted well into January and quickly unwound in February. Admittedly, valuations were stretched, especially given the recent rise in yields and weakness in the dollar. The return of volatility caught most investors off guard.
Volatility resulted, in part, from the consensus view which had not properly discounted geopolitical risks. The new year brought renewed threats to the global economy from economic populism and nationalist agendas. In the U.S., President Donald Trump finally acted on previously misbelieved campaign rhetoric by using his executive powers to impose tariffs on steel and aluminum imports and starting the process of implementing more expansive import taxes on Chinese goods. The status of the North American Free Trade Agreement (NAFTA) also remains very much up in the air as, despite signs of progress, Trump continues to bash the treaty and suggest U.S. withdrawal. In all, the first quarter of 2018 showed the vulnerability of markets to the risks posed by more restrictive trade policies and domestic agendas.
Political uncertainty was on the rise across emerging markets during the first quarter. Specifically, there were several significant regime changes. In South Africa, embattled President Jacob Zuma stepped down allowing his African National Congress party successor, Cyril Ramphosa, to assume the presidency before the 2019 elections. Meanwhile, Pedro Pablo Kuczynski, the pro-market candidate who won the Peruvian presidency in 2016, was forced to resign or face impeachment. In China, Xi Jinping successfully changed both party and government rules allowing him to consolidate power further giving him the prospect of lifetime rule. In Saudi Arabia, Crown Prince Mohammed bin Salman, aka MBS, continued with an expansive agenda which includes promoting economic diversification, social reform and solidifying Saudi Arabia’s regional leadership, all while taking actions to reaffirm loyalty to his future accession to the throne.
In March, the new Federal Reserve Chairman, Jerome Powell, reminded investors that they are late in the accommodation cycle as the Fed increased short-term interest rates by 25 basis points. Given aggregate global debt levels, rates are unlikely to go much higher this cycle (Figure 1). Rising real rates are very punitive to the prospect of extending the economic cycle. Furthermore, long-term rates surprised investors and have fallen recently, causing a flattening of the curve.
Meanwhile, the seasonal tendency toward slower growth occurred as usual despite widespread anticipation of a growth surge. The Atlanta Fed’s GDPNow is currently forecasting 2.4% growth, down from over 5% earlier this year (Figure 2). There were already signs last summer of slowing Chinese growth. European growth momentum may have peaked at year end.
Overall, growth remains solid but is not accelerating at a pace that will encourage central banks to become more restrictive. Inflation globally remains in check and fears that wage growth and commodity prices would gap higher, causing a more aggressive response from the Fed, the European Central Bank and the Bank of Japan, proved premature (Figure 3).
Looking ahead, it appears that global stock markets are attempting to reprice risk against a backdrop of high valuation, modest growth and a perceived risk of rising real interest rates. Monetary conditions will likely continue to be less friendly. Tighter financial conditions should put pressure on equity valuations. However, earnings growth should remain strong in the short term. Given the tendency for stock market volatility late in an economic cycle, it is probably the beginning of the end rather than the end of the bull run. While recession risks are rising, it is unlikely to be realized in the current year. We are still 12 to 18 months away from any severe contraction of global economic activity.
The dollar will continue to be pressured by U.S. fiscal and trade policy. Interest rate differentials will not be attractive enough to lure foreign investors especially as investment opportunities in Europe and Japan are more compelling than they have been in years. Meanwhile, the growth rates in emerging market countries continue to exceed those in the developed world. Commodities are benefiting from typical late cycle pressures. Demand is starting to improve relative to supply which should lead to higher prices favoring commodity producers over commodity consumers. Global economic momentum will continue if left unchecked. However, the rising threat is the fear of broader restrictions on the free flow of goods and services or a more extensive trade war. It is indeed early, but indications are that there is more posturing than policy. Moving forward in 2018, we will continue to be watchful for possible policy errors and the inherent risks.
As the year progresses, political events will come fast and furious, with the potential of creating economic headwinds. Of note, are the several national elections across Latin America which could dramatically alter the political dynamics of the region. In May, Colombia will elect a new president. The leading rightist candidate, Iván Duque, has campaigned on undoing the 2016 Peace Accord negotiated with the Revolutionary Armed Forces of Colombia, potentially jeopardizing the country’s stability and economy. Andes Manuel Lopez Obrador, known as AMLO, a left-wing candidate is the front-runner for President in the Mexican general elections to be held in July. His stance toward re-regulating the energy sector, fuel subsidies and price controls could prove detrimental to the nation’s oil industry but popular with the citizens. Finally, Brazil will hold its general elections in October which will elect a new president. Polls show former President Lula leading among the dozen potential candidates, despite being jailed as he appeals a criminal conviction that would bar him from office. Political uncertainty about Brazilian leadership and policy could derail the nascent economic recovery.
Political uncertainty is nothing new to Latin America, nor to the rest of the world. However, there has been a noticeable shift in the risk tolerance of investors concerning geopolitical risk. It would be naïve to assume that markets will not experience more volatility resulting from adverse political outcomes. However, we believe that most disruptions will provide investment opportunities. This is particularly true in emerging markets where expectations for political risks are high. Mexico, for example, is likely to trade poorly into the election this summer. The results though are unlikely to disrupt its improving economic fundamentals. Furthermore, there has been measurable progress in NAFTA negotiations which will likely more than offset the political risk.
It seems that things may always feel worse than they are. That has been the nature of this bull market. It is not as good as it feels at market tops and not as bad as things feels at market bottoms. We are somewhere in the middle. Securities are priced too dear, and valuations are likely to decline. We view declines in equity prices, wider credit spreads and higher interest rates as part of the value restoration process. We will look for a more favorable entry point to add to risk. The bull market is not over.
We are late in the economic cycle, but favorable fundamentals should win out over a gradual tightening of financial conditions for now. This is particularly true for emerging markets. As the world has become smaller and globalism has evolved the traditional linkages between markets have become more correlated. Nevertheless, emerging markets have lagged returns in the developed world and are set to catch up. From a portfolio perspective, the opportunity set has expanded while the risk mitigation from diversification is compelling.
©2018 Northwest Passage Capital Advisors LLC. All rights reserved
To download the PDF version, click here: Apr 2018 – Things are Better Than They Seem