After an unprecedented 16 months of consecutive gains, it was not surprising that global equities experienced a sharp rise in volatility at the end of the first quarter of 2018. Initially, there was a sharp sell-off in February. While the monthly decline in US equities was 4.2% in February, the fall approached 10% at one point during the month. The MSCI Emerging Markets Index fared even worse, with a decline of 4.6%.
TURBULENCE IN THE EQUITY MARKET
These falls were essentially due to an equity bull market that has risen for a very long time without any material correction. The trigger for the sell-off was most likely concern about rising inflation and bond yields, with the 10-year US Treasury yield having risen from 2.41% at the end of last year to a high of 2.95% by mid-February. Commodity prices fell along with other risk assets, with Brent Crude and natural gas down by 6% and 7% respectively during February. However, the heightened volatility during late March and early April was due to a more specific event – the escalation in retaliatory exchanges between Washington and Beijing regarding terms of trade. This elevated concerns of a nascent ‘trade war’.
Although a little technical, another factor needs to be highlighted. Against this fundamental backdrop, a ‘volatility event’ related to the rapid liquidation of short-volatility positions in inverse Volatility Index (VIX) products appears to have exacerbated turbulence in the equity market. That was reflected in a 116% increase in the Chicago Board Options Exchange (CBOE) VIX on 5 February, which was its largest ever one-day change.
This event was not unlike the ‘flash crash’ of May 2010, given that equity volatility spiked far more dramatically than the volatility of rates, currencies or oil prices. A study of this 2010 event by the US Securities and Exchange Commission (SEC) observed that “the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets”.
We believe that volatility of this magnitude, rather than being an outlying event, might well be the new normal. During this period, there was no protection to be found in bonds or gold, while equity sector diversification did not help either. All assets correlated.
The massive inflow into passive management has played a big role in creating this new environment. It is estimated that the exchange-traded fund (ETF) industry’s assets under management stood at $4.6 trillion at the end of 2017. In 2017 alone, ETF assets grew by over one trillion dollars compared to the US mutual fund industry that recorded growth of a mere $91 billion. Passive capital inflows therefore outgrew active flows by a factor of 10. During the first week of February, ETF outflows were $30 billion, which was sufficient to cause significant market disruption. This of course begs the question as to what would happen if these outflows were far larger, the point being that an outflow of, say, $300 billion will be a small percentage of recent flows into ETFs, yet the impact on volatility and correlations will most likely be extreme.
The correction in February left the MSCI World Index and the MSCI Emerging Markets Index trading at reasonable levels of 16.0 and 12.4 times estimated earnings, which suggests that valuations alone are not an impediment to the resumption of the global equity bull market in coming quarters. However, any ETF outflows aside, even modestly rising inflation pressures and further gradual movements toward interest rate normalisation among major developed market central banks suggest a continued move towards more normal levels of equity market volatility, certainly relative to the extremely passive conditions of 2017.
Meanwhile, investors will continue to watch key risks closely. These include US inflation and interest rate pressures, the possibility of a significant slowdown in China in response to the negative credit push, rising trade tensions as the Trump administration seeks leverage in trying to renegotiate trade tariffs and the ever-present ‘tail risk’ of the rising geopolitical risk associated with the nuclear standoff between the US and North Korea.
GLOBAL GROWTH OUTLOOK BUOYED BY CURRENT MOMENTUM
Notwithstanding recent concerns and increased volatility, we believe that the bull case for equities will endure for a while yet. The synchronised global expansion seems set to continue for several years, inflation remains moderate on a global basis, central banks are still providing ample liquidity and equities continue to look attractively priced relative to government bonds.
We believe that the fundamental outlook for global growth and interest rates is little changed from where it stood at the start of 2018. Global economic data continues to reflect an impressive, broad-based global economic expansion. Economists estimate that global manufacturing output accelerated to a 5.5% annual rate in the last quarter of 2017, its fastest pace since 2010.
As last year’s second-half rise in energy prices begins to dampen consumer spending, the pace of this expansion is expected to ease somewhat this year. However, there is sufficient momentum in the global economy that labour and product market constraints in developed markets should push both wage and core CPI inflation higher in coming quarters, along with expectations about central bank policy rates.
Outside the US, there has been relatively little change in expectations regarding monetary policy among the major central banks. Despite a noticeably stronger Eurozone economy, the European Central Bank is still on an extremely gradual path toward policy normalisation. Quantitative easing is widely expected to end only in September, while the first rate hike is not expected until the first or second quarter of 2019. In Japan, officials continue to stress that no change in its quantitative easing programme should be expected anytime soon, but economists there believe that the Bank of Japan may ratchet up its target level for 10-year government bond yields from the current level of zero to 0.25% by the end of the year. In both Canada and the UK, interest rate futures markets predict the most likely scenario for further rate hikes coming at each central bank’s May meeting.
Taking a longer-term perspective, although we are late in the economic cycle, ongoing cyclical tail winds should fuel economic resilience in the US over the next 24 to 36 months.
A key driver of this surprising resilience is the growth created by the coming of age of American Millennials, overlapping peak spending by Generation X families and the ageing but still healthy Baby Boom young seniors.
Collectively, the maturing of the core of a large generation exaggerates consumer demand, workforce productivity, capital investment and economic growth. Housing is an important component of this. In the US, estimates are that 400 000 housing units are lost each year, for example through demolitions and fires.
To keep pace with the net rise in American household formations, at least 1.5 million new units must be built each year over the next decade. While the number of housing starts has rebounded slightly over the past three years (after the post-2008 supply glut absorbed from 2010 to 2014), building is still far below what is needed to meet rising Millennial Generation demand. Supply shortages have fed housing price inflation and set the stage for a further rise in residential construction across the country.
Additionally, following the 2008 financial crisis and global recession, many analysts had forecast that annual US new vehicle demand would never rebound above 16 million units. This belief was built on the understanding that the pre-crisis numbers were inflated by subprime lending, high fleet sales and irresponsibly low lease-end residuals.
Yet demand has rebounded back to a cyclical high above 17 million units per year. Although sales may soften slightly this year to about 16.8 million units, the consistently strong numbers are due to lower income taxes and rising household incomes, and full-time employment and wages for Millennials, the largest market for new vehicles over the next 12 years.
INVESTOR CONCERNS ABOUT INFLATION ON THE RISE
As alluded to earlier, for the first time in many years, investors are becoming increasingly concerned about potential inflation, particularly in the US. This concern is based on the acceleration in the US hourly earnings to a 2.9% year-on-year pace in January, while the CPI rate also jumped by a greater than expected 0.5%.
Additional concerns arise from the fact that, on a forward-looking basis, US fiscal policy is becoming highly expansionary at a time when the economy is already at full employment. Based on the combined effect of previously announced tax cuts and a US budget deal in February that increases government spending by almost $400 billion, estimates are that 0.7% will be added to GDP growth in 2018 and 0.6% in 2019.
This has raised concerns that the Federal Reserve (Fed) will need to push up interest rates more than was earlier expected. Interest rate futures are now pricing in a 35% chance that the Fed will hike rates four or more times by the end of this year, even though the most likely scenario remains for just three rate hikes.
Taking a longer-term outlook on inflation, in our opinion, demand-pull inflation is no longer a force in the industrialised Northern Hemisphere, with the exception of the US. Essentially, this is due to the secular ageing and imminent contraction in the populations of Western Europe, Eastern Europe, Russia, Japan and South Korea. China will soon follow along this path, as its working-age population has already begun to shrink.
Since the US population is still growing, albeit slowly, brief surges of demand-pull inflation are still possible. However, ongoing contraction of consumer demand across most of Europe and North Asia will mute or offset such cyclical pricing power over the next few decades. While currency weakness or supply disruptions will cause periodic short-term local or regional inflationary pressures, any such pricing power will be short-lived due to the slow but inevitable deterioration of demand in the industrialised north.
Over the next decade, resilient US demand and rising per capita consumption in emerging South Asia are likely to offset demand weakness in Europe and Northeast Asia. However, the collective global shrinkage of demand will become more pronounced in 10 years as population ageing and contraction outside the US gathers momentum. Therefore, while investors must focus near term on modest pricing pressures created by the US- and China-led synchronised rise in global growth, any inflationary pressure is likely to be muted and short lived.
While manipulation of monetary and fiscal policies may temporarily boost input and consumer prices, over the longer term fewer high-income consumers will lead to reduced demand for food, energy, materials, goods and services. Meanwhile, year-on-year consumer inflation is moderating or under control in the world’s three largest emerging economies.
Put another way, if the populations of Europe and Northeast Asia were growing at a rate similar to the US, it can be argued that there would not have been a decade-long distortion of extremely low interest rates. As is well known, some of the consequences of these policies are blown-out equity price-earnings ratios, as well as impacts on asset allocations, commodity demand and over-leveraging in a reach for real yields.
To give this perspective, we know that an individual consumes more at age 40 than at 60. The ageing of Europe and Japan has thus had a significant negative impact on collective global demand, and in turn, on pricing power for materials, goods and services.
Looking forward, the drag will become even more pronounced as most countries in the industrial north see their populations age further and decline in number. Fewer and older is a recipe for decline in demand, economic growth and public sentiment, and as a consequence, potentially political stability. While inflationary pressures will most likely see a late-cycle lift over the next 18 to 24 months, this pricing power is likely to prove temporary as secular deflationary pressures take hold during and beyond 2020. Therefore, while fears of deflation and recession are currently giving way to worries about overheating due to recent ill-timed fiscal stimuli, it may not be long before investor concerns begin to turn back toward fears of stagnation, and the social pressures associated with stagflation.
POSITIVE US ECONOMIC DYNAMICS REMAIN
In summary, fears of a near-term US recession should fade as we move into the second quarter, as the stimulus created by tax cuts, federal spending hikes and modestly higher wages boost consumer spending and capital investment. This is of course based on the view that it is in neither the US nor China’s interest to allow a full-scale trade war to take hold.
However, this late-cycle growth is likely to dissipate later next year and into 2020 as rising interest rates dampen public and consumer spending and cause renewed job market anxiety. That said, while momentum investors will expect this slowdown to become irreversible, the positive dynamics of virtuous US population demographics should surprise the pessimists and reward long-term investors with a resumption of strong economic growth from the US. This will widen the divergence between North America and the ageing and contracting populations of Europe, Japan, Russia, South Korea and most of China.