Investment Risks for the First Quarter
In spite of the headlines, they are more economic than political
If investing is all about understanding the market’s expectations, then the wisest words about last year’s markets came from a seasoned pro who remarked: “They’ll keep going up because everyone’s underweight.”
With all of the fundamental and technical analyses showing that neither stocks nor bonds could possibly keep appreciating, few investors or economists believed in a blow-out year. Even those who were comfortable with the steep valuations kept a wary eye on geopolitical risks from Venezuela, Korea or Washington that might puncture the market’s enthusiasm. And because expectations trended toward the pessimistic, investors were rarely disappointed and the headlines flowed past in a rose-tinted hue: good news seemed great; neutral news looked good; bad news barely dented the broader consciousness.
But as 2018 rolls into view, investors might do well to pay attention to two new warning signals. First, the market almost never delivers consecutive blow-out years. Second, expectations have been rising quickly. For the first time in seven years, economic growth outperformed economic forecasts which has forced upwards expectations for 2018 that will be more difficult to meet. And while the geopolitical risks are getting most of the attention in this year’s forecasts and headlines, the most likely end to the current run will still come — sooner or later — from a conventional turn in the cycle of the world’s two largest economies. The most likely dangers remain sharper Fed hikes or slower Chinese growth.
New Guns at the Federal Reserve
Any warning that markets might turn must begin with an acknowledgement that the last few years have delivered a potent five-part cocktail for financial asset prices: 1) sustained economic growth that is broadly synchronized across major developed and developing economies, 2) falling unemployment that has boosted domestic demand, 3) extremely loose monetary policy that creates amply liquidity, 4) restrained commodity prices amid slower Chinese demand and new alternatives to Middle East oil, and 5) both low actual inflation and, more important, low expectations for future inflation.
The great puzzle in all of this has been how inflationary pressures have been kept at bay, generating all sorts of new thinking about whether or not the traditional correlations between unemployment and inflation have dissolved. But there are signs in the recent data that productivity growth has returned, and with it pressures for higher wages. Even if this proves anomalous this time, there is clearly no sign that the new leadership at the Federal Reserve has bought into any new paradigm. If anything the names who seem likely to take their seats with incoming Chair Jay Powell at the Federal Open Markets Committee’s deliberations tilt toward hawkish traditions. They will at the very least deliver hikes along the path of the current dot plots and perhaps more. For all the Sturm und Drang around the recent U.S. tax reform, it seems likely to deliver only a small fiscal boost, but it’s a boost nonetheless that comes very late in the cycle and will tilt rate-setters toward faster hikes. Recent commodity price strength and dollar weakness may also fuel inflationary pressures, even if the dollar itself should drift stronger on Fed tightening.
The weak link in the U.S. economy, as usual, will be the consumer. Recent trends show that personal savings rates are now back near pre-crisis levels of 3 percent, while housing prices are still growing twice as fast as wages. Meanwhile, manufacturing expansion will face currency headwinds that will weaken export growth, and a whole lot of leverage in the system will quickly grow more expensive. If rates at year-end are closer to 3 percent than 2.5 percent, then the S&P 500 will be closer to flat than soaring.
For the first time in a long time, investors around the world will also face the confusion of asynchronous monetary policy. With the U.S. tightening, other major central banks show little sign of changing course. Even amid the good news from Japan with tightening labor markets and recovering domestic demand, the Bank of Japan’s dogged governor, Haruhiko Kuroda, is not about to fall short of his 2 percent inflationary target. The European Central Bank, moreover, seems to have resisted political pressures to tighten too soon, and German negotiations over a new governing coalition may weaken any renewed attack. While the Bank of England sneaked in a well-telegraphed hike last November, any further increase seems unlikely as the British economy awaits the outcome of its painful Brexit negotiations.
Three things to watch: Actual productivity gains that will boost wages, further declines in U.S. savings rate and a new trading range for oil.
China’s Core Leader and Core Inflation
The Nineteenth Communist Party Congress enshrined Xi Jinping as “Core Leader,” an honor bestowed only on the strongest of his predecessors and a signal that he holds economic and political strategy firmly in his hands. He stressed the need to reduce inequality across regions with more infrastructure investment, more innovation in the private sector and a clean-up of State-Owned Enterprises, and a better focus on the quality of life, including protecting the environment. Of course, it’s a big country and there’s a lot that could go wrong.
Both inflation and core inflation (that strips out energy and food costs) are under control, leaving the People’s Bank of China free to curtail excess leverage in the system with more targeted macro-prudential measures. Still, given the opaque debts that link China’s state enterprises to one another and continuing speculation in the housing market, there is plenty of room for financial accidents. Moreover, while Chinese leaders appear less focused on a specific growth target, most forecasters have a number around 6.5 percent in mind and this could slip amid the government’s focus on environmental rules and rooting out corruption. The base case is probably continued stable growth for China, which would support stable global growth forecasts. But even a small deviation from expectations could undermine expectations across a whole range of asset classes.
Slower Chinese growth, combined with unsynchronized global monetary policy, will make for a volatile year in Emerging Markets. So far, they have benefitted from strong demand and a weak dollar, which is generally the best of all possible worlds. India’s economy continues to boom near 7.5 percent following last year’s disruptive currency reform, with Prime Minister Modi continuing to press for change. Russia offers upside as well, since real rates remain high and the Central Bank has plenty of room to cut. The likes of Turkey, Indonesia and Brazil, however, may find it more difficult to keep the attention of international investors if U.S. rates rise faster than expected.
Geopolitical Risks that Won’t Trigger a Selloff …
If the economic risks are most likely to end the current rally, it’s important to understand the political risks as well. Some are actually dangerous, but perhaps not the one that get the most attention.
On the top of most lists of political concerns for 2018 are countries where the politics are opaque and the risks look dire. Nuclear brinksmanship in Korea is naturally a top contender, followed closely by the economic collapse of Venezuela. Popular unrest in Iran is unfolding even as a new Crown Prince upends expectations in Saudi Arabia. Yet as tragic or politically consequential as each of these crises may be, it remains difficult to see how they may have more than a temporary impact on the discounted earnings streams of most of the world’s listed companies. Of course, a drastic spike in oil prices might have global repercussions, but even new leadership in key Middle East exporters will need to resume exports soon and there there seems to be plenty of supply at the right price. Military confrontation on the Korean peninsula would be disastrous for those two countries and likely dampen North Asia’s economic outlook significantly. All else equal, most scenarios would not likely tilt the entire world economy into recession.
Investors have circled their calendars for some important election days this year. Russia’s presidential vote seems to hold the fewest surprises, which would make any disruption a very big surprise. Again, however, the impact outside of Russia itself will be limited. Italy’s election could bring anti-European 5-Star politicians into a coalition government, but they will not be able to drive significant change to the European Union. Mexico’s vote holds the highest level of uncertainty with populist Andres Manuel Lopez Obrador leading in the polls. His victory will raise tensions with President Trump and undercut further progress on the renegotiation of NAFTA, but an outright trade war that tips the world into recession seems remote. Even the wildcard Trump Administration itself will continue to erode U.S. global leadership with its erratic departures from the traditional bipartisan consensus, but a years like the last one will not likely trigger crisis on its own.
Three things to watch: anything other than the risks cited here.
… and those that might.
By definition, the unknown unknowns are unlikely to find their way into even the most erudite of market commentaries. Still, the real worries arise when earnings streams either fall or seem at risk of falling in unpredictable ways. This makes scenarios like epidemics or cyber attacks especially dangerous, as they carry the risk of infecting people or data networks at speeds and along patterns that are difficult to forecast. The financial damage of the SARS epidemic was largely limited to Asian markets, but that was only because the disease was largely contained there. The Wanna Cry ransomeware attack last May disabled systems in Russia, India and Taiwan; it’s hard to imagine a more random pattern and it seems that only a chance discovery of a “kill switch” helped prevent a further spread.
Broader geopolitical risks to markets would come from a dramatic realignment of the world’s largest economies on key geopolitical questions. A fundamental trans-Atlantic rift that dissolved NATO would clearly unsettle projections for US and European economic growth. That’s difficult to imagine today. More likely, perhaps, would be a rapid sharpening of tensions between the US and China that threatened military hostilities enough to undermine the world’s largest economic relationship. This might arise over the South China Seas or North Korea. Currently, all of the Permanent Members of the U.N. Security Council are broadly aligned on the need to apply pressure on the Kim Jong Eun’s nuclear tests. The prospect of Moscow and and Beijing cutting a deal with Pyongyang without Washington would fundamentally realign global expectations in ways that could raise risks to a lot of questions around current earnings forecasts. The most prominent would be who will cooperate with whom when the next financial crisis strikes?
Three things to watch for: any headlines about cyberattacks, any headlines about pandemic risks, Trump tweets signaling that a China trade showdown is unlimited and unlinked to cooperation on Korea.
4Q17 Results: Short S&P 500 (+6.1%), Long USD (-1.0%); Short FTSE (+4.4%) and GBP (+0.7%); Long Stoxx 600 (+2.6%), Short EUR (+1.6%); Long Nikkei (+11.8%), Short JPY (-0.2%); Long China (+6.5%), Long RMB (+2.1%); Long EEM (+5.1%).
1Q18 Calls: Short S&P 500, Long USD; Short FTSE and GBP; Long Stoxx 600, Short EUR; Long Nikkei, Short JPY; Long China (CSI 300), Long RMB; Long EEM.
Christopher Smart is a Senior Fellow at the Carnegie Endowment for International Peace and the Mossavar-Rahmani Center for Business and Government at Harvard University’s Kennedy School of Government. He was Special Assistant to the President for International Economics, Trade & Investment from 2013–15 and Deputy Assistant Secretary of Treasury for Europe & Eurasia from 2009–13. He is also Associate Fellow at Chatham House.
