It is often said that markets climb a wall of worry. Today, optimism is thin on the ground in spite of some positive signs from the global economy. In the spirit of Christmas, shouldn’t we all just relax and enjoy it?
Just 10 countries in the world are predicted to see negative growth in 2018. Some may argue that that is ten too many, but it makes a marked contrast to 2009, when over 100 countries were in recession. Equally, each of these recessionary countries has their own unique, usually political, reasons for their difficulties. Venezuela, for example, has been brought low by political and economic mismanagement, while Puerto Rico is still suffering the effects of Hurricane Maria and Equatorial Guinea has been hurt by falling oil reserves and high debt.
It is telling that none of these countries are major economies with unfettered access to global markets. In other words, none have been direct beneficiaries of the global liquidity surge brought about by quantitative easing.
In the meantime, however, the rest of the world is in party mode – with steady economic growth providing a supportive backdrop for companies and consumers. We are now in a situation where world output is expected to grow 3.7% (source: OECD) in 2018. This is stronger than it has been for years.
Unusually, all this has happened with almost no rise in inflation. The most recent Eurozone statistics show headline inflation at 1.5% and core inflation at just 0.9%. This is in spite of current year on year growth of 2.5%. Mark Nash, head of fixed income at Old Mutual Global Investors says: “The lack of wage inflation, and indeed general inflation has been astonishing….Markets find themselves in a strange dichotomy where no-one is afraid of inflation or central bank surprises.”
It has also happened with almost no volatility. The CBOE Volatility Index (Vix) remains at historic lows.
The question is whether we should all just chill out and enjoy the moment. After all, good economic news has been thin on the ground since the Financial Crisis and it would be good to be able to stop worrying.
Yet Rob Burdett, co-head of multi-manager at BMO Global Asset Management, sums up the feelings of many when he asks: “Does the economy look a little bit too good to be true? It seems to be enjoying a ‘Goldilocks moment”” He has a point. These Goldilocks moments have not tended to end well. If it looks too good to be true, maybe it is.
Certainly, there appear to be elements of complacency – perhaps notably in the low volatility. Ian Heslop, head of global equities at Old Mutual Global Investors, says low volatility is no longer informative on the prevailing market sentiment: “Low volatility is not telling you about uncertainty in markets. These stats have to be carefully used. The stats are saying everyone is relaxed and sanguine, but that is not the case.”
Equally, it would be a whole lot easier to relax were valuations not so demanding. The OECD recently cautioned investors that asset prices are too high for a global economy that looks likely to peak next year. Heslop adds: “The ‘in-price for shares is the best predictor of what you will make.” Everything may look benign, but if that is fully reflected in valuations and the economic environment moves to anything less than perfect, investors will get burned.
What might change the environment? There are a few candidates. In particular, the monetary policy environment is changing. The liquidity that has supported the system is ebbing away, albeit slowly, and central bankers are no longer as desperate to get lending going at any cost. Inflation remains a risk and with it, the prospect of higher interest rates.
Nash adds: ”We are past peak dovishness…The political backdrop means that there could be fiscal expansion at a time when the economy is already strong.” He believes this is not priced into markets.
So perhaps it is appropriate to worry after all. Markets can always stay buoyant for longer than you expect and the party may carry on a little longer, but it can be worth leaving a bit on the table for the next guy.