Market Priced Volatility and Real-World Uncertainty
Economic expansion in advanced economies is expected to continue into next year, led by rising household consumption and business investment. The U.S. Fed is expected to continue slowly unwinding QE while raising rates, and the ECB is likely to begin to taper its asset purchases during 2018. Prospects for emerging economies have improved as Brazil and Russia emerged from recession. China’s economy is likely to slow, but only gradually.
While the world is experiencing synchronous growth, record low volatility has created low correlations within and among asset classes. What appears to be a Goldilocks economy is coexisting in a low volatility environment that may be a trap, a situation where excessive monetary stimulus keeps asset prices rising and volatility low across markets even though real economic risks are rising. Central bank stimulus directly lowers risk premiums and volatility in rates and credit markets, pushing investors into riskier assets to generate sufficient returns. However, the inequality resulting from this stimulus has increased geopolitical instability.
Concern remains low as markets continue moving higher and volatility remains at record lows. The gap between soft economic data (survey-based) and hard data (official data releases) has widened. Optimistic soft data and low inflation have helped produce positive returns while hard data has detracted. Meanwhile, we haven’t seen emotional reactions to geopolitical risks that have unknown consequences. The U.S. is an open economy and foreign capital flows will go where conditions are most attractive and geopolitical risk and policy errors will at some point be reflected in markets, eventually bringing volatility back.
Though efforts to reduce leverage and capitalize banks since the crisis have resulted in a safer financial system, we currently have more indebted governments, higher inequality and increased geopolitical risks. These opposing factors have created a divergence in market volatility and real-world uncertainty.
Rising wealth inequality coupled with lack of social mobility provides the economic conditions for a rise in protest politics. The Brexit referendum and the U.S. and French presidential elections spurred protests. Unexpected results from the UK referendum and U.S. elections triggered an increase in global economic policy uncertainty. Neither event sparked a market selloff, thanks to quick easing actions from the BoE and an improvement in U.S. growth and fiscal policy. Future risks may be the catalyst for a market response. These risks include tensions in the Middle East and between the U.S. and North Korea and investigations over President Trump’s Russian links.
Currently, foreign money is making its way to the U.S. bond market suppressing long-term U.S. rates, causing the yield curve to hold at some of its narrowest levels in a decade while inflation remains dormant. Although the Fed can continue raising short-term rates, long-term yields would remain low until inflation accelerates. This relationship could be tested in 2018 as the Fed plans to begin reducing its balance sheet assets. We will continue to monitor this and the apparent disconnect between geopolitics and the markets.
Four Themes
1.The Puzzle of Low U.S. Inflation
There is concern that central bankers and creating uncertainty regarding the sustainability of the recovery by steering the economy without the benefit of a reliable theory of what drives inflation today. Inflation has been lower than expected for several years, explained by lower growth. Central banks can more slowly normalize policy and reduce the risk of a policy mistake that would cause a recession if inflation is low and there is less economic overheating. Equities prefer low inflation, since low rates on cash and bonds make stocks look more attractive.
Low inflation results in a weakening economy, lower earnings growth, and a future problem with central bank’s ability to raise the economy out of the next recession. Central banks in developed markets collectively identified this concern and have committed to do everything they can to bring inflation up to their target rates.
Since the beginning of 2017, U.S. growth has improved while inflation remains below target. The Fed and other central banks have set their inflation targets too low given the realities of their economies. There has been downward pressure on the long-term neutral rate of interest applied by rising inequality, growing regional savings gluts and aging populations that slow demand. The ability to lower rate, which has been a primary tool for fighting recession, has become less effective.
Part of the low inflation problem relates to the dollar. Large, abrupt swings in the dollar tend to be more correlated with large, abrupt swings in import prices with much less pass-through to inflation.
The broad dollar index is now at its lowest since April 2016. Fed models indicate that for every 10% trade weighted appreciation in the dollar, core PCE inflation is reduced by 0.5% in the two quarters following the dollar’s move and the four-quarter effect is to reduce core PCE inflation by about 0.3%¹. Therefore, it is conceivable that much of the deceleration in core PCE inflation from 1.9% at the start of this year to 1.4% as of August was due to the dollar’s prior appreciation¹.
2. The Unknown Impact on the Yield Curve with the Reversal of Unconventional Monetary Policy
A gradual normalization of bond yields as growth improves and central banks exit QE should be positive for financial stability. By next year most central banks are expected to begin the process of unwinding the $20 trillion in financial assets that they purchased over the past decade. These outflows could lead to asset declines and liquidity disruptions. The timing would be determined by the pace of central bank normalization. While policy rates are rising in the U.S., Canada and U.K., financial conditions remain loose due to demand for bonds, creating headwinds for those central banks who are moving in the tightening direction.
The Federal Reserve has begun to unwind the massive balance sheet that grew significantly following the financial crisis of 2008, to above $4.5 trillion. The process of shrinking the balance sheet would be gradual and take many years, initially reducing at $10 billion a month.
The added complication is that it is impossible to know exactly what impact QE has had, in part because it is impossible to disentangle it from all the other forces affecting the economy. QE has boosted equity prices but the ripple effect on household spending and GDP has been small. The marginal effects of QE diminished as the program expanded. There is debate about whether it is the stock or flow of purchases that matters. It is unlikely that the Fed will be able to cheapen the Treasury curve through raising the term premium via reduced reinvestment. Unconventional policy tightening is not a substitute for conventional policy tightening.
The view that the Treasury term premium will rise less materially than it fell is based on many other considerations affecting the Treasury market. They include:
- Balance sheet reduction may be slowed or reversed at some point due to late cycle concerns and uncertainty around timing the business cycle.
- The actions of other major QE central banks whose balance sheets wouldn’t be shrinking for years or would continue to expand even at a slower pace in future.
- The Fed has very limited ability to cheapen the Treasury market on its own. If foreign central banks hesitate to allow their own yields to rise materially, connected carry trades adjust for FX hedging risks.
- Improved stock markets may merit a safe-haven bid that preserves demand for Treasuries.
An additional consideration is that the initiative was more than offset by increased public-sector borrowing. Continued demand among mutual funds, pensions and insurance companies for fixed income created the opportunity for non-financial companies to ramp up issuance. It’s one of several supply factors that have been identified explaining why bond yields globally remain historically low. The large portfolio rebalancing in fixed income was a switch within private sector securities. There was a shift from financial securities into Treasuries, along with non-financial corporate and overseas debt. That is changing as financial institutions are back issuing more and keeping their supply of securities to the market stable.
3. Global Growth is not Synchronized – The World is Out of Step with U.S. Monetary Policy
Global growth is accelerating and the OECD estimates that all 46 of the economies that it tracks will see positive growth this year for the first time since 20072. Weak productivity across most of the world is likely to create congestion that would increase inflation and reduce business investment spending. Since the U.S. currently leads this growth in advanced economies, a U.S. slowdown would have a significant impact on growth in the rest of the world.
The growth in most global economies have been supported by monetary stimulus may be causing some side-effects, including asset bubbles, worsening wealth inequality and misallocation of resources. Persistent low interest rates resulting from monetary stimulus have rolled forward a growing amount of private and public debt to future generations. Technology is deflationary and there are fewer young people able to carry a higher debt burden in the future.
The boost in growth has taken long to materialize and is occurring in the context of muted financial volatility. As we discussed earlier, the recovery still falls short in delivering the high inclusive growth that is needed to deal with a long list of accumulated economic, financial, institutional, political and social challenges.
4. Protectionism in Developing Countries
The economics behind the North America Free Trade Agreement (NAFTA) are powerful. Trade is a high priority for the President, who has unilateral executive powers to effect change. Revisiting NAFTA will be an important test of direction for the United States and on their willingness to use trade as a bargaining chip regarding geopolitical tradeoffs.
The United States sells more to Canada than it does to China, Japan and the U.K. combined. Contrary to recent rhetoric, the U.S. currently has a trade surplus with Canada. In negotiating NAFTA, the current list of U.S. demands opposed by Canada includes3:
- A “sunset clause” that would automatically terminate the deal in 5 years if all 3 countries did not endorse it again at that time.
- A rule requiring all cars to be made with 50% American content if they are to be exempted from tariffs.
- Dismantling of Canada’s protectionist supply management system for dairy and poultry.
- A “Buy American” procurement policy limiting Canadian and Mexican access to U.S. government contracts.
- The end of the current independent tribunal system for resolving NAFTA disputes.
History has demonstrated that when there are trade restrictions, both countries get hurt. Countries are better off to use internal tax policies within their country to deal with the inequality within that country. For the same reason that there is no balanced trade among U.S. states, it is not realistic to strive for it among countries. We will be monitoring developments resulting from NAFTA negotiations as they will have a significant impact on not only Mexico and Canada but the entire global economy.
Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.
Deborah Frame, CFA, MBA
President and Chief Investment Officer
October 19, 2017
1 Scotiabank Global Economics. Scotiabank’s Global Outlook. October 5, 2017.
2 BCA Research. Global Investment Strategy. Strategy Outlook Fourth Quarter 2017 Goldilocks And The Recession Bear. October 4, 2017.
3 TheStar.com. Donald Trump’s ‘outrageous’ demands put NAFTA negotiations at risk of collapse as talks resume Wednesday, experts say. Oct 10, 2017.
