2018 kicked off with quite an optimistic investment outlook. The anticipated tax cuts in the United States, continued central bank support and stronger global economic conditions were but some factors that backed this view. Now however, while economies have generally continued to maintain a fair degree of growth, the upside momentum - except perhaps for the US – has waned to some extent.
The first half saw some volatility in markets as trade wars made it onto the scene, something that was underestimated by a market caught in a generally positive sentiment for even much stronger markets. Developments around Brexit and Italy further clouded the investment picture with indicators of peaking economic growth lately and notably a softer Chinese GDP print adding to the story. The volatility blow in early February and the sharp sell-off in Italian bonds in May are examples of what investors have had to face during the first half of this year. Inflation has generally picked up somewhat largely due to the increase in oil prices, but has not as yet lived up to expectations of a generally strong move to the upside given the better global economic outlook that prevailed at the start of the year. It remains relatively contained in most countries at this point in time.
The US Fed is on course to likely increase rates further in light of a fairly good US economic picture and a pick-up in recent inflation. The European Central Bank is expected to taper its asset purchases towards year-end. China has been intervening in its economy to ensure more stable lending and financial markets. All these developments imply one thing for markets, and that is that financial conditions will become tighter as central banks slowly and increasingly move towards endeavouring to normalise the ultra-supportive monetary policies that were designed for and implemented during the Global Financial Crisis.
Tighter financial conditions, especially on the back of a stronger US Dollar and now coupled with trade wars or protectionist concerns, have introduced uncertainty in markets. The positive market outlook is now questioned, especially since markets have not been too friendly during the first half of the year as expected and performances have been disparate - with better runs in the US and some other markets, a negative Chinese market, a bearish US bond market, property prices losing upside momentum in some major cities around the globe, etc.
Economists Carmen Reinhart and Kenneth Rogoff with the publication of their book “This Time is Different” in 2009 gave much food for consideration. The book presented an in-depth study and research on financial crises since 1400 AD. Their key conclusion was that after a major financial crisis, an economy needs on average some seven to ten years to recover before conditions start normalising.
The major central banks have been engaged in unprecedented unconventional monetary policies for at least this amount of time to ensure that the world does not fall into the grip of a deflationary spiral and that economic growth gains traction in the face of the immense credit/financial crisis at the time. Fast forward to early 2018, it would seem that their efforts have indeed paid off.
Many studies have shown that the unprecedented monetary policies have lowered interest rates and boosted asset prices. But whether this has been matched by the extent of growth in the real economy could be questioned. Also, not much financial stimulus has made its way to the real economy via the traditional banking system and normal price discovery by the market has been significantly disrupted since the financial crisis. The reliance on unprecedented central bank support via quantitative easing and other stimulus measures has remained central to where we are today.
Trade and currency wars will impact global trade and thus economic growth negatively. Coupled with tighter monetary and financial conditions as more central banks start on a quantitative tightening trajectory, investors face an outlook that is uncertain. Will the global economy successfully transition to a more normalised environment in the face of these developments and the shrinking global liquidity that would result? Keep an eye on the stock market as it is a barometer of sentiment and will provide early cues to economic growth and developments ahead. But concerning the stock market itself, investors should not ignore the signals that indicate that we are potentially in the latter stages of the market cycle.