In many ways, 2017 marked the culmination of the global recovery from the financial crisis.
The scars from 2008 surely remained and all of the wounds hadn’t healed, but the “synchronous” character of global growth suggested that nearly a decade of accommodative monetary policy had finally succeeded in acting as the proverbial rising tide that lifts all boats.
You’ll recall that the vaunted “Goldilocks” narrative depended on two pillars of support for its viability: synchronous global growth and still-subdued inflation across developed market economies. Don’t let the irony inherent in that situation be lost on you. Global growth was supported by accommodative monetary policy, and the durability of that policy regime effectively rested on the assumption that inflation wouldn’t accelerate too rapidly. But the whole purpose of accommodation was to engineer inflation, which means there was a sense in which the ongoing success of easy money policies in propping up global growth relied on those policies partially failing when it came to achieving their original goal of driving up inflation. Had inflation accelerated too rapidly (or, put differently, had those policies been “too” successful), they would have been rolled back, undercutting growth.
In any case (i.e., that paradox aside), it’s important to note that growth wasn’t the only thing that was “synchronous” in 2017. While accommodative policies didn’t trickle down as quickly as expected when it came to producing real economic outcomes, those policies were remarkably effective (and extremely efficient) at inflating the value of financial assets. As policy became more predictable and as DM central banks fine-tuned their communication strategy with markets, everything began to converge on one trade. Recall the following from a January note penned by Deutsche Bank’s Aleksandar Kocic:
Through their communication with the markets Central banks, and the Fed in particular, have become “good listeners” with their decisions and actions made with markets’ consent. After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.
Shortly after that piece was written, things began to change, starting with the VIX quake in February. As BofAML’s Barnaby Martin suggests in a note dated August 9, we may be witnessing “the end of synchronized everything.”
“The most notable trend in markets is that of performance dispersion, and examples abound almost everywhere”, Martin writes, before listing a series of examples across assets:
Take Turkey vs. Russia debt for instance, or Apple vs. Facebook shares, or value vs. growth stocks, or even US Treasuries vs JGBs. Assets that were previously well correlated, are now witnessing a much more diverse performance of late. And in credit land it’s much of the same…note the significant outperformance of single-As relative to BBBs over the summer period (chart 1), or the number of bonds dropping conspicuously across the European high-yield market (chart 2).
In that context, it’s worth noting that on the heels of the recent turmoil in the JGB market (see here and here for more), the range in Japanese 10Y yields last week was wider than Treasurys for the first time in two years.
lol the range in Japanese 10Y yields last week was bigger than USTs for the first time since 2016
(h/t @HBmacro) pic.twitter.com/MYIgrgwjPN
— Luke Kawa (@LJKawa) August 9, 2018
Tellingly, that’s the direct result of the Bank of Japan attempting to get back on the same page with the Fed and the ECB when it comes to policy. With the Fed continuing to hike apace and the ECB set to end its asset purchases at year end (reinvestment flows notwithstanding), the BoJ was falling further and further behind. The volatility in JGBs is indicative of what can happen with asymmetries emerge and policymakers attempt to “correct” them. As far as the policy divergence between the Fed and the ECB is concerned, well, just ask Bill Gross about that.
Asynchronous outcomes have manifested themselves in credit markets this year as well, with investment grade turning in an abysmal performance in the first half of 2018 amid concerns about the extent to which the space has become synonymous with macro-systemic risk (think: sensitivity to higher rates). Meanwhile, high yield continued to benefit from the prolonging of the cycle and the continued suppression of defaults, as the effects of accommodation linger.
At the macro level, U.S. fiscal policy is leading directly to asynchronous growth outcomes. In short, 2017’s synchronous growth narrative is quickly morphing into a U.S.-centric story about the likelihood that late-cycle stimulus can prolong what was already the second longest expansion in history. At the same time, the threat of a trade war is weighing on sentiment abroad. Absent a concurrent fiscal push from ex-U.S. economies, growth outcomes are likely to diverge further. For his part, JPMorgan’s Marko Kolanovic thinks a coordinated fiscal stimulus effort is a possibility. Recall this from his latest note, dated July 30:
The US often sets global trends, such as the introduction of QE in the aftermath of the 2008 financial crisis. QE was later replicated (and taken to another level) in Europe and Asia. At the end of his term, chairman Bernanke said that there are limits to monetary policy and that pro-growth fiscal measures need to play a bigger role. Trump fully on-boarded this as a part of his platform. Corporate tax cuts can also be viewed as a part of the trade war. Corporate tax cuts outside of the US might be a necessary step in order to compete in trade, especially after the massive reduction in US tax rates. Fiscal measures are also popular with voters and can help reduce various political tensions, e.g., exposed by the recent rise in populist movements in Europe. For this reason, we think that is quite possible that in coming quarters Europe and Asia will move towards fiscal easing. Instead of a 2019/2020 recession, we may see a boost to the global cycle driven by Trump-style fiscal measures outside of the US.
In the meantime though, America is setting a different course with consequences that beget still more asynchronous outcomes. For instance, the deluge of Treasury supply necessary to finance the tax cuts helped catalyze a dollar funding crunch in Q1 and the threat that late-cycle stimulus will push up domestic inflation is leading the Fed to lean more hawkish than they otherwise might. As dollar liquidity is squeezed, so are emerging markets which then face an impossible choice: hike and risk choking off growth or don’t hike and risk the policy divergence with the Fed leading to currency weakness and capital flight.
At the hear tof it all: populism. In the same BofAML note cited above, the bank’s Martin says the following, which echoes Kolanovic, although not necessarily with the same positive connotation:
Yet, rising dispersion is the clearest reflection of how the investment backdrop has fundamentally changed, in our view. The synchronisation of global growth, central bank policies and corporate fundamentals of yesteryear has given way to a more challenging world of diverse politics, economies and liquidity support.
Much — although not all — of this sea change has been instigated by the rise of populism. In our view, this has helped reshape many of the hitherto market norms.
Martin goes on to note that the gradual rolling back of globalization has led to declining foreign direct investment and a collapse in world trade volumes. To wit:
Chart 3 shows how cross-border capital flows have evolved over the last few years, a good proxy, in our view, for measuring how globalization is changing. While not all measures are in retreat, what looks to be suffering more is Foreign Direct Investment, which has declined from 4% of GDP in 2015 to just 2.4% recently. Chart 4 shows the conspicuous drop in world trade volumes over the last few months despite a global economy that continues to hum along fairly well. As a result, the casualties have mounted: witness the recent plunge in German factors orders (-4% MoM), even though US GDP in Q2 (+4.1%) was the strongest since Q3 ’14.
What are the implications going forward? Well, that depends on how predisposed you are to believing that the world is prepared for a kind of sea change in the dynamics that defined 2017.
Generally speaking, no one would be willing to go out on a limb and suggest that a sharp slowdown in global trade and commerce would somehow be a positive development. Rather, the hope is that reason triumphs over protectionism and globalization over isolationism.
When it comes to markets, one thing seems virtually certain: “the end of synchronized everything” (as BofAML puts it) means more volatility across assets.
That should be viewed in light of epochal shifts in market structure, where that means analyzing the ramifications of HFT proliferation, having an honest discussion about the possible pitfalls of passive investing’s meteoric rise and/or taking a hard look at liquidity provision and the potential for market fragility to manifest itself in flash events.