When last we checked in on Barclays’ global head of macro research Ajay Rajadhyaksha, he was busy documenting how quickly things returned to some semblance of “normal” following a tumultuous Q1 during which investors were forced to digest i) a violent reaction to ostensibly innocuous signs of wage inflation, ii) the largest VIX spike on record and iii) a subsequent unwind in systematic strats, whose forced de-risking contributed to the violent price swings that characterized the first week of February.
“Three months ago, investors seemed skittish about every headline”, Rajadhyaksha wrote in late June, in the foreword to the bank’s global macro outlook piece that served as a look ahead to the back half of the year. “After a shaky Q1, risk assets have their mojo back, with EM the only major asset class to underperform”, he continued.
Fast forward to September and the bank is back with their latest global outlook strategy note, a 68-page, cross-asset tome that touches on everything from trade wars to U.S. politics to oil to NATO.
At this point, everyone knows the narrative. We all like to feign incredulity at the resilience of U.S. assets in the face of geopolitical turmoil and domestic political strife, but the paradox is that the same policies that are supporting U.S. stocks are undermining ex-U.S. assets.
Late-cycle fiscal stimulus catalyzed a buyback binge and bolstered corporate bottom lines, but piling expansionary fiscal policy atop a late-stage expansion risks overheating the economy. The higher the risk of overheating, the more hawkish the Fed. The more hawkish the Fed, the more near-term dollar strength. The stronger the dollar, the more pressure on ex-U.S. assets and especially assets that are vulnerable to the Fed’s tightening cycle.
At the same time, U.S. trade policy serves to undercut global growth and exacerbates jitters around assets tied to economies whose fate depends on the outlook for growth. Simultaneously, the threat of tariff-related price pressures contributes to the Fed’s hawkish lean, which engenders more dollar strength, and around we go in a self-feeding loop that feeds the divergence.
Recently, the narrative has shifted, with the “convergence trade” gaining traction as EM central banks step up efforts to defend their currencies and worries about the U.S. fiscal trajectory weigh on the greenback.
It’s against that backdrop that we bring you the foreword to Barclays’ latest global outlook piece penned, as usual, by the above-mentioned Ajay Rajadhyaksha.
If there is one constant in financial markets, it is the prevalence of ‘noise’. Investors are constantly bombarded with bits of information, tons of research, and hordes of opinions. Sifting through it all – zeroing in on the little that matters and ignoring the rest – is key to successful investing. Rarely has this adage been truer than in recent months. Based on the headlines and the breathless opinions expressed in the financial press, asset markets should be coming apart. After all, two of the world’s biggest economies are in a full-on trade war, with no end in sight. And every second day brings news of an emerging market in trouble. Even so, year-to-date, global equities have returned over 6%, the S&P500 has returned over 10%, and US high yield spreads are 25bp tighter. European equities, while they have lagged the US, have had a small positive return, after double-digit returns last year. What is going on? How does an investor reconcile such returns against, say, the currencies of Turkey and Argentina losing over 50% vs. the USD? At the risk of over-simplification, and to misquote James Carville, it’s the US economy, stupid.
Despite the EM headlines, the most important economic development this year has been the stimulus-fuelled US economic resurgence. It is hard to imagine the US keeping to the 4%+ growth pace set in Q2. But the world’s largest economy is set to have a very healthy 2018, with growth of nearly 3%. This surge, coupled with slow-but-steady Fed hikes, has sparked a new round of capital inflows into the US, boosting USD assets. Despite slowing early this year, Europe and Japan look set to grow above trend, supported by super-easy monetary policy. The global economy is more dependent on the US than in 2017, but our aggregate growth forecasts have not come down much. However, we recommend keeping a close eye on developments in EM and on the macro effects of US trade policy.
We feel that the ‘EM contagion’ narrative – that weakness in EM will spill over to the developed world – is overblown for now. Excluding the high-profile but smaller EM economies (such as Turkey and Argentina), EM equities, for example, have not done much worse against the US than non-US G10. Moreover, non-China EM economies are just not big enough to upset growth in the advanced world. China is slowing as well, but we expect a new round of stimulus to keep growth near 6.5% for both 2018 and 2019. Mind you, our relatively positive mindset about global macro does not extend to EM assets themselves; it is not yet time to buy the EM dip. EM currencies should struggle unless the Fed changes tack, which is very unlikely in 2018. US-China trade frictions are likely to worsen further, which should also weigh on EM financial assets. The good news is that the effect of this trade war on US and Chinese growth looks manageable so far. But there is no denying that downside risks have increased, and trade is likely to be a recurring macro theme for the next few quarters.
In sum, the next few months should look like the previous few, with global equities outperforming global fixed income while climbing a wall of worry on trade, longer rates staying range-bound, EM currencies struggling against the USD, and the US Fed marching on. Expect plenty of further noise, though, on EM, on US and European politics including the US mid-terms, and on trade.