Disrupting the Momentum
With the end of 2017 near, the leaders of our investment platforms gathered to talk about the evolution of the investment environment over the past 12 months and what they expect for 2018.
Joe Amato: The optimism of the “reflation trade” that ended 2016 gave way to a “Goldilocks” environment over the course of 2017, fueling the rise of risk assets of all types and geographies. We remain in that “just right” state as we enter the new year, with synchronized global growth for the first time in a decade, low inflation and low volatility.
Tony Tutrone: The economic momentum is undeniable. All 45 countries tracked by the OECD are expected to expand in 2017, which has only happened three times over the past 50 years. The U.S. is running above 3% and nearing full employment. Euro zone growth has broadened beyond Germany and the Netherlands, and the region is finally keeping pace with the U.S. Japan’s in the midst of its longest quarterly growth streak in more than 20 years. China continues motoring along even as Beijing pushes toward sustainable long-term reforms.
Erik Knutzen: I think all this makes 2018 a particularly challenging year to forecast, especially from a full-year perspective. Though I expect the positive impulse to extend into the early part of 2018, obstacles ratchet up significantly as the year progresses, moving us away from Goldilocks into something more complex.
We anticipate monetary tightening will really start to be felt about midyear, when year-over-year growth in G-4 central banks’ balance sheets is expected to turn negative. Obviously, the Fed is furthest along in terms of normalization. December’s hike brought the upper bound of the fed funds rate to 1.5%, and the Fed is forecasting three more hikes in 2018. While its balance-sheet reduction has been uneventful so far, the runoff accelerates in 2018 and will reach its monthly maximum of $50 billion by the fall. The European Central Bank plans to halve its monthly asset purchases beginning in January, and it may look to move its policy rate off zero later in the year. The Bank of Japan may be slower to act given its multi-decade battle against deflation, but it will become increasingly difficult for the BOJ to defend open-ended stimulus measures with the Fed and ECB heading in the opposite direction.
Brad Tank: In general, I think that the synchronized global growth will transition to a synchronized global plateauing in 2018. The business cycle is aging rapidly, and the tighter conditions Erik mentioned could start to weigh on its ability to persist. That said, I don’t expect a U.S. recession in 2018, though 2019 and 2020 are viable possibilities. China’s continued deleveraging, which may accelerate in 2018 behind an even more powerful Xi Jinping, will also play a role in dampening the global economic acceleration. Less liquidity and slowing but reasonably strong economic growth combined with high valuations should result in renewed volatility across financial markets.
I also see signs that inflation may pick up globally in 2018. In fact, I think conditions are more hospitable for an increase in inflation than they have been in years. The output gap in the U.S., for example, has closed completely, and rising productivity should pressure wages higher. Producer prices in China have climbed sharply in the past two years, which should ultimately be felt in consumer prices in many markets. On top of this, many countries are intent on introducing expansionary fiscal policy and reform initiatives. The U.S. passed a $1.5 trillion tax cut. French President Macron has turned out to be as pro-business as advertised; in just a few months in office he has liberalized labor laws and cut the deficit, and we expect more reform in 2018. Japan’s recent budget calls for growth-oriented fiscal policy. Brazil is looking to trim pension costs in an effort to get its public debt under control.
Should these efforts spur a meaningful acceleration of inflation, central banks may be forced to act more quickly than they had planned to—and more quickly than markets expect.
Amato: It’s really an unprecedented—and precarious—time for central banks as they manage the unwind of years of extraordinary accommodation. We’re basically in uncharted territory, and the Fed has a new hand at the tiller in Jay Powell. He’s been a Yellen ally since he joined the board in 2012, and I expect his approach will be consistent with the groundwork she laid. That said, the degree of difficulty is certainly higher now than it was a year ago. Meanwhile, the seven-member Fed board of governors is understaffed, with three vacancies currently and two more coming in 2018.
Knutzen: The Fed isn’t the only place with job openings. Trump has had a hard time filling the seats in his administration, at both the cabinet and sub-cabinet levels. Only about one-third of the key positions in the administration requiring Senate confirmation have been filled; two-thirds of the Treasury’s positions remain open and half are open at Commerce. While part of this can be attributed to Democratic stonewalling, a lot is due to a lack of qualified candidates willing to serve. And it’s troubling that some of the most capable members of the administration—people like Cohn and Tillerson—don’t seem like they’ll be around much longer.
Tank: I think we can agree that Washington in general seems like it has the potential to be a source of market headwinds in 2018. It looks like the Mueller special investigation will continue to make headlines, whether or not the president ultimately is implicated in any collusion with the Russians. And it’s safe to expect a contentious midterm election season in 2018. There’s a very real chance that the Democrats take back the House in 2018—if they do, that may increase the chances that Trump could be impeached in 2019. With Republicans likely to keep hold of the Senate, the possibility of Trump’s removal is remote, though a divided Congress would result in political gridlock. Come June and July people will start looking toward the polls to see how these races are trending, which may rattle markets.
Tutrone: We managed to get through last year’s slate of European elections relatively unscathed. This year Italy is the only major country up for grabs, with parliamentary elections taking place in March. Italy is still the third-largest economy in Europe, though it also has the second largest debt-to-GDP ratio and a recovering banking system. Polls suggest that there’s a possibility that an anti-establishment, anti-Europe party, like the Five Star Movement, could rise to power there.
There are some interesting emerging markets political races coming up in 2018. Mexico elects a new president in July. The poll leader there—Andres Obrador, a left-wing populist—has been outspoken about his distaste for NAFTA. Should he win, trade negotiations with the U.S. could grow even more contentious. In Brazil, the runaway leader in the polls is a former president who was caught up in the Petrobras corruption scandal and may be facing prison time.
On top of potentially disruptive elections, you have the usual sources of geopolitical discord. North Korea continues to lob missiles and is always unpredictable, as is the potential U.S. response to any provocation. Brexit talks continue in Europe, and while there’s been some progress, a final accord appears far off.
Amato: In contrast with the wild cards Tony mentioned, there’s much less uncertainty in China after Xi cemented his leadership following the most recent Communist Party congress. As a result I think Xi may be more aggressive than most people expect when it comes to promoting economic and financial reforms and risk containment. China typically doesn’t announce its GDP growth target until March, but it wouldn’t be surprising to see it again set at 6.5% for 2018. While it beat that bogey easily in 2017, this year will be more of a challenge should Xi follow through on aggressively reining in credit and cutting excess industrial capacity.
Knutzen: At the end of the day, we need to acknowledge the positive economic context in which we will be making our investment decisions. In short, strong macroeconomic fundamentals and corporate earnings are real and underscore the case for remaining exposed to growth. The challenge for investors is to do so in a prudent way, with risks skewed as far as possible in their favor.
Asset allocation becomes more challenging in a world of high valuations, a maturing economic cycle and shallow, short-lived market dips. From a multi-asset class investment standpoint, our approach for 2018 must be predicated on finding those asset classes and subsectors where meaningful upside potential is still available, and then seeking to extract that upside potential in more sophisticated, risk-controlled ways.