Here we sit, barely two weeks into the new year, and guess what? Risk assets have already blown through some analysts’ full-year projections, with both equities and HY (for instance) rallying further than some of the less sanguine (yet still optimistic) year-end 2018 targets.
What’s the catalyst? Well for one thing, the narrative is holding. “Goldilocks” is alive and well. The synchronous global growth story gets a new piece of supporting evidence seemingly every day and Friday’s hotter-than-expected CPI print in the U.S. notwithstanding, there’s little evidence to support an argument for aggressively hawkish central bank forward guidance.
Additionally, despite the Fed balance sheet rundown and the ECB taper (APP will be cut in half starting this month), Citi notes that “the increase in EM FX reserves recently, with Chinese FX reserves doing the majority of the heavy lifting, has gone some way to offset” DM normalization. There’s more than a little irony there considering the China news on Wednesday.
At this point, everyone seems to generally agree that a sudden uptick in inflation is the biggest threat to the “everything bubble”. After all, subdued inflation is the more important of the two pillars holding up the Goldilocks narrative. Central bank predictability (“transparency“) is what keeps carry trades and yield enhancement strategies (e.g. vol. selling) viable as markets cannot see outside the communication loop with policymakers and thus shortermism/myopia takes hold, with dealer hedging serving to reinforce local stability. An upsurge in inflation could very well break that spell.
This is familiar territory. Everyone knows that higher than expected inflation, a withdrawal of central bank predictability, and a concurrent spike in rates vol. is the most readily identifiable dynamic that could pop the central bank bubble.
But what are the other possibilities? That is, are there other pins that could burst the balloon? For their part, BofAML sees three additional risks.
Paradoxically – given that a sudden increase in inflation is the biggest risk – a lack of reflation could pose a problem as well. Here’s BofAML:
On the other hand, markets may lurch back to debt sustainability worries if inflation refuses to rise that much. In Europe, core inflation has now come in at 0.9% for three months in a row, reminiscent of the end of 2016. A slower than expected rise in inflation – at a time when central banks are exiting stimulus with little in reserve to fight the next downturn – could shatter market confidence, leading to a sell-off in risky assets. Herein lies the Quantitative Failure risk for markets in 2018.
Another risk is that central banks finally have a come-to-Jesus moment and deliberately burst the bubbles they’ve blown in the interest of not inflating them further. Here’s BofAML on that:
If it’s not inflation (or lack thereof), then central banks may simply feel that the time is right to sound more hawkish in order to preserve financial stability and prevent a misallocation of capital taking hold. After all, stable rates encouraged the proliferation of leverage in the run up to the Global Financial Crisis of ’07-’08.
We’ll leave it to readers to assess how likely that is.
The fourth risk is perhaps the most interesting of all and it underscores something at least one other sellsider has been saying for the better part of a year. Namely that populism is a risk.
“It could be populism that upends the central bank support for credit markets [despite it being] the proverbial dog that didn’t bark in 2017, as investors shied away from a Frexit vote,” BofAML notes, adding that while the populist narrative may be “down,” it is far from “out”.
The bank goes on to discuss the dynamic that will be familiar to many: QE has exacerbated inequality and thus contributes to the resentment that fueled the populist narrative in the first place. Here’s more:
Income and wealth inequality continue to be important catalysts stoking resentment towards mainstream political parties. And in an era of central bank QE, financial assets have strongly outperformed real assets since 2012. As the charts below show, income inequality has risen across the world over the last nearly 40 years.
How does that translate into a catalyst for the bursting of the central bank bubble? Simple: populism is inflationary. Here’s BofAML explaining how xenophobia, isolationism, and deglobalization could serve to burst your bubble (figuratively and literally):
But populist parties’ views are often dominated by the insular thinking of “us first” as opposed to agendas that continue to foster globalization. While the populist narrative is becoming more aggressive, confrontational and xenophobic as time goes by, the risk is that some of this rubs off on mainstream parties as they try to win back voter support, and they start sounding more populist themselves. As Chart 16 shows, more countries experienced declines in “freedom” in 2017 compared to those that registered gains in “freedom” – the 11th such consecutive year. This amounts to a test of globalization, in our view. And a more mercantilist approach to global trade could create less efficient supply chains for corporations, which would be inherently inflationary. And by default, this could provoke a more hawkish message from central banks.
So there you have it, the four things that (could) burst the central bank bubble. Pick your poison.
And don’t forget to hedge.