BMA 2018 Global Macro Outlook: Make Way For Volatility FINAL

After the U.S. elections and Brexit rocked 2016, 2017 was a relatively calmer year for the markets across the board. Tides will likely turn as disruptive forces, a year of “unknowns” and increased volatility will keep market practitioners on their toes in 2018. While the relative historic levels of volatility may remain low, BMA believes leveraged asset prices will increasingly be vulnerable to shocks, which could lead to larger swings in asset prices. Central bank activity, geopolitical risks and current high asset valuations are among the key drivers behind 2018 market jitters.

Central Bank Activity

Global central bank activity remains a focal point for investors. Improved economic conditions could easily prompt central banks to tighten monetary policy faster than expected. BMA predicts at least four rate hikes by the US Federal Reserve in 2018 as inflation is poised to edge higher (see Figure 1 below).

While keeping a pulse on their respective domestic outlooks, the central banks will undoubtedly keep an eye on the broader global economy, particularly how China’s slowing growth prospects coupled with their highly leveraged households and corporates may impact other emerging economies and the developed markets.

BMA believes that the global economic story has shifted from a “secular stagnation”, that is no or very low economic growth in a market-based economy, to that of a global harmonized growth story. In fact, the IMF upped its global GDP growth forecast for 2018 to 3.7% from 3.6% last October.

A few key points regarding Central Bank activity:

• BMA forecasts four rate hikes versus the Fed’s current median prediction of three hikes and the interest rate futures market currently pricing in nearly two hikes, as of this writing.

• We expect the incoming Fed chair, Jerome Powell, to relax regulations for financial companies, which could then further encourage consumer lending and increase the money supply into the US financial system.

• Unemployment is currently at pre-crisis levels with the U3 headline unemployment rate at 4.1% and the U6 unemployment rate (which includes the underemployed and discouraged workers) at 8%. With US employment near maximum levels, the Fed’s medium-term inflation goal of 2% (currently core PCE, less food and energy, inflation is 1.48% YoY) is within reach. The heavy drivers of higher inflation in the U.S. could be prompted by:

As the Fed continues to unwind its massive $4.5 trillion balance sheet and increases short-term interest rates, the US yield curve will continue its bear flattening posture. Historically, a bear flattening yield curve indicates an economic recession is imminent. However, the flattening of the curve in the current environment is due to the rise in short-term rates rather than long-term (10-Years and longer) as the Fed and central banks globally unwind or scale back quantitative easing and monetary stimulus. In fact, the flatter curve has been prompted by investors chasing yield with the added benefit of relative flight-to-quality securities as opposed to concerns regarding weaker growth and inflation.

U.S. 10-Year Government Yields Remain Relatively High

• Across the pond, it is worth mentioning that the European Central Bank (ECB) will also scale back its bond buying program from €60 billion to €30 billion a month beginning in January with the possibility that the bank extends its economic stimulus program beyond September.

Potential Impacts of the Fed Rate Hikes

• The U.S. dollar will likely be on the rise as Fed rate hikes continue and as the ECB has signaled it will not raise rates until after it ends its bond buying program.
• The unwind of the Fed’s balance sheet coupled with an increase in selling more debt to fund an expanding US budget deficit will eventually lead to higher long-term treasury yields. US treasuries are considered to be the risk-free-rate, in theory.
• Higher interest rates may lead to a correction in the stock markets and negatively impact overleveraged companies and economies.

Geopolitical Risks

Geopolitical risks also take center stage with a number of key elections, negotiations and rising tensions in the East notably between North Korea and most of the world.

Political Uncertainty Across the Globe (Figure 2)

1. Rising tension in East Asia between North Korea and everyone else.
2. NAFTA negotiations, which could have rippling effects on other global trade deals.
3. Middle East instability, particularly in Iran and Saudi Arabia.
4. 2018 elections: Italy (March 4), Brazil, Mexico, Colombia and Russia.
5. In Germany, Angela Merkel’s CDU-CSU party has yet to form a coalition government.
6. Continuing Brexit negotiations and potential for the Labour party to make electoral gains ahead of a possible 2019 general election.
7. Midterm elections in the U.S. present an opportunity for Democrats to win the House of Representatives, which may thwart President Trump’s agenda.
8. Regulation: Trump’s proposed deregulation on the banks.

Other Risks

• Asset valuations continue to increase across market instruments while volatility remains relatively muted. As volatility begins to creep up and with the greater probability of higher rates, stock markets and overleveraged alternatives become increasingly vulnerable to downward pricing pressures.
  • Global QE pressured US Treasury yields lower than they normally would be, driving traditional asset allocations to alternative assets such as private equity and hedge funds.
  • Alternative assets are relatively illiquid and highly leveraged. In a downturn scenario, investors may be challenged to exit their investments at a profitable return.
• Disruptive technology, including the rise/fall and uncertainty around crypto currencies may impact investors.
• Weakened global growth impacted by China’s economic slowdown (hard landing): inflated housing prices and an over-leveraged economy. China’s total non-financial sector debt will rise to almost 300 percent of its GDP by 2022, up from 242 percent last year, according to an August 2017 IMF report.
• Crude oil surpassed the $60/barrel benchmark late last year, as BMA predicted. We expect oil to continue to rise on the back of global growth, though Iran and China could be a major downside risk, BMA predicts oil to hold steady at $65/barrel.

While investors globally continue to benefit from economic expansion, the low volatility experienced over the past several years within fixed-income, credit, commodities and equity markets will not last forever. Navigating the potential actions and/or unexpected events driven by central banks, geopolitics and/or the mispricing of assets will only drive the probability of higher market volatility.

To see how you may benefit from these themes, reach out to your BMA partner.

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