21 September 2017
Animal Spirits called to account
The cyclical uptick in the global economy that commenced with the assistance of (yet more) global central bank easing back in early 2016 has been an enduring one. This now prolonged cyclical uptick in an otherwise secular environment of muddle through low economic growth, low inflation, low bond yields, and highly indebted economies, has nonetheless been pushing the upper end of post crisis GDP ranges and doing so for an encouraging period of time.
The pro-business ‘Animal Spirit’ like sentiment boost that followed the US election did afford further momentum to this economic upswing. However, as we head toward the end of 2017 we call to account the beliefs that so many had embraced at the beginning of the year and suggest they have not played out anywhere near as consensus had expected. The ‘soft’ intangible influences (in preference to overwhelming hard evidence) that so many had embraced as reasons to be optimistic about growth in 2017 have not eventuated – not even close. Yet accountability for this hopeful embrace is unlikely to be assigned, nor the mistakes learned from, as thankfully, economic growth has remained encouraging.
Indeed our March newsletter questioned the latest market narrative of pent up Animal Spirits spurring a ‘return to normal’ and highlighted the very likelihood that this narrative and associated surge would likely reveal itself as little more than just another leap in assumptions, like so many others experienced since the financial crisis of almost 10 years ago now. The March note highlighted that the soft-data hope would be challenged by the well-known evidence based structural challenges facing the global economy and that this hope would sooner or later encounter structural reality. As we head toward the end of 2017, the lack of progress on just about all the pro-business initiatives, has seen the Animal Spirit optimism fade and market themes evolve considerably.
The major theme for 2017 was the market not only embracing new pro-business policies (including tax reform, infrastructure etc.) but also pricing in the belief that these policies would work. As we conclude the September quarter, it is now clear that the execution of these has disappointed considerably, and some markets have adjusted accordingly. Bond markets have defied the relentless consensus calls for higher yields (for the 8th year in a row, but who’s counting? Or indeed accountable) and shifted back lower in yield, and similarly the US dollar has weakened notably. Credit and equity markets on the other hand appear to have replaced optimism for pro-business reform with a focus on current and expected growth, which is fine as long as growth continues. The weaker US dollar has offered an unexpected benefit to global trade and global GDP as it has relieved pressure on China and commodity export dependent emerging market economies. This has supported and lengthened the current global economic upswing, not ‘Animal Spirits’.
No progress? Well some...
Concluding that there has been no progress isn’t fair or accurate. While it is true that there has been a lack of progress on ‘reflation’ initiatives, the new US administration has made progress on many of the more America first protectionist policies that it had also campaigned on. Interestingly financial markets had largely discounted or dismissed these policies as being irrelevant to the economic outlook and therefore have not formed part of the latest narrative or market pricing.
While ‘Progress!…. just not in the areas the market anticipated’ has had little discernible impact on global trade and economic growth up to this point we are concerned that this notable shift could restrain global growth over the longer term. Adding to the well-known structural challenges that the global economy faces. Debt, demographics, digitalisation, dependency on central bank support, and now the evidence of increased risk of de-globalisation/protectionism, adds further support to our conviction in our medium term view that we are very much "Stuck in the [ever increasing indebtedness] muddle". Our concerns that recent shifts in the political landscape appear increasingly likely to add to the challenges, rather than aid them, are playing out.
For us, at MIM Fixed Income, we have also taken time to strategically review markets holding our third and final Strategic Forum for 2017 in early September, setting forth a basis for approaching the many fixed income and currency markets for the medium term. In doing so, we came to appreciate that many of our views for 2017 had now become consensus – the predominant theme of scarcity of yield and therefore a chase for yield as the primary influence of fixed income markets has borne out – thereby now raising our level of alertness. As such our Forum focused more on the forward looking themes for the markets and concluded that these have evolved considerably. As highlighted above, all but gone are any expectations of fiscal stimulus and in their place are concerns that the short term benefits (the disappointment reflected through a lower US dollar) currently being experienced will form into larger long term costs.
Nearer term, we outlined that markets needed to afford much more attention to further Central Bank stimulus withdrawal or ‘less easing’ as we like to refer to it, tempering the chase for yield. The changing make-up of the US Federal Reserve with many vacancies (that the administration will get to fill) and the very real possibility of a new Chairperson and therefore philosophy is, we believe, being under-appreciated by markets. Finally and more importantly the potential for lower Chinese growth after the late October National Congress is an area to watch, especially as this has been the recent driver of better global growth. We believe these major themes are more likely to drive markets in the coming months and hence should form the basis of our portfolio positioning.
Reflecting on the current full valuations exhibited in so many markets and the nature of these evolving themes, we concluded that a more conservative but cautious stance with relation to credit exposures was appropriate. For bond exposures we maintained our bias to accumulate duration particularly on any sell off. More strategically, we continue to hold the view that the bond yield environment is likely to be driven by the structural realities facing the global economy and therefore expect bond yields to remain contained - duration is not to be feared, rather accumulated at the upper end of recent ranges.