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What have we been up to


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At the crossroads

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Let us go back in time a little to the end of 2016 and imagine trying to compile a list of things to worry about in 2017. It might have read something like this:
Euro crisis flaring up again
China’s credit bubble bursting
Housing bubbles in Canada, Sweden and Australia popping
FED tightening pushing the US economy (and through that the entire world) into a recession
Geopolitical risk (you can probably put that down in any given year)
UK economy falling off a cliff due to Brexit (depending on your political views)
Trump (again depending on you political views, although I should note that at the time stock markets had responded very positively to the Trump presidency)
In light of the above, one might have been forgiven for thinking that 2017 was going to be the year the world would fall apart, but obviously, it didn’t. Quite to the contrary, it went pretty well.
The global economy grew, undeterred by all the risk and uncertainty, by an estimated 3%. China’s economic expansion slowed, but there was no more reason to worry about its trajectory than there had been in the previous years, begging the question of whether you should worry at all. The FED steadily continued its normalisation of interest rates and started unwinding its balance sheet without triggering a global recession. Despite all the Brexit doom and gloom, the UK economy was doing just fine and Europe seemed on the mend, prompting both the BoE and the ECB to change their rhetoric in autumn 2017 (conspicuously shortly after the Jackson Hole central bank gathering in summer) and guide markets towards higher interest rates.
Strong stock market performance mirrored the economic picture.  Take the S&P 500 as a case in point. The index closed higher two thirds of the time on a weekly basis returning an overall 18.3%, the largest weekly drawdown was a mere -1.4% and the VIX volatility index fell to a level of 9%.  As things were going reasonably well, it seemed that sentiment also shifted among the economic and financial intelligentsia. Instead of stark warnings about the risks to growth, there was increased talk of a synchronised and broad global recovery, in particular towards the end of the year, underpinned by promising economic data. The catchy, yet utterly annoying, chorus of The LEGO Movie song “Everything is AWESOME!!!” was an apt description of how it felt to read financial news.   
But then, amidst all this optimism, stock markets got a little jittery in February this year and taught complacent investors a tough lesson. For the first time ever the Dow Jones declined 10% within 9 days after making an all-time high. Volatility returned as the VIX exploded from 9% to 35%, completely wiping out those who had been betting on an ever-rising XIV (the inverse VIX). More importantly, the negative correlation between equities and bonds that is commonly observed during such drawdowns broke down, with rates rising amid the sell-off.
Since then, sentiment and economic data have softened and geopolitical risks have mounted, yet central banks, in particular the FED, seem unfazed and remain committed to their tightening agenda. As a result, the potential for policy errors has an increased. In a previous bulletin my colleague Shane Canavan discussed the spectre of an inverted yield curve, one of the most reliable recession indicators there is, and argued that we needn’t worry (yet). I am tempted to agree and was surprised to find out that the overnight FED funds forward curve is already inverted from the two-year point onwards (albeit only very, very slightly). At the same time, interest rate expectations are the highest since 2015 in EUR and GBP and since 2010 in USD.
There is certainly a strong case for short-term interest rates to move higher and now is not the time to be complacent about interest rate risk. But given how the ‘economic narrative’ appears to be changing once again, it seems equally inadvisable to be complacent about the possibility of a recession and yet more repetition of the “lower for longer” mantra.
To me it feels like we are at a crossroads, poised to find out whether the global economy can weather a synchronised tightening by three of the major central banks or whether the FED has already pushed things too far. Loose credit conditions and the still historically low high-yield spreads suggest we are late in the cycle and not far away from the turn, but given how slow this recovery has been, we might as well be half-way between nadir and top.
I hope it is the latter. But hope usually is a bad strategy, which is why I suggest preparing for both outcomes.
Upcoming data releases
As regards the UK, there is a flurry of economic data to be released on Tuesday and Wednesday, among them CPI and RPI numbers which are expected to come in at 2.7% and 3.5% respectively, i.e. still above the BoE’s CPI target of 2%. In contrast, Eurozone inflation, to be published on Wednesday, will most likely print at around 1.4%, suggesting rising inflation is still not yet a problem in the common currency area. The upcoming ECB and BoE meetings (next week and in May) will shed some further light on the inflation dynamics in both economic areas. For the US, initial jobless claims are expected to remain in the region of previous prints with surveys pointing towards 230k.    



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