“The largest risk to the global central bank ‘easing parade’ and end-of-cycle ‘Slow-flation’ consensus would be a good old-fashioned ‘bottoming-out’ [and] ensuing bounce in global growth data”, Nomura’s Charlie McElligott wrote Tuesday, underscoring the extent to which, with the Fed and the ECB both pot-committed to rate cuts in the very near-term, the real land mine for risk assets is a convincing upturn in growth that prompts markets to ponder whether insurance cuts will be just that, not the start of an actual easing cycle.
For McElligott, that kind of positive inflection in the growth data would kick off two pain trades, one in rates (a front-end selloff and concurrent bear flattener) and one in equities, where cyclically-sensitive shorts like Value would outperform duration-sensitive longs like Growth and Min. Vol.
Marko Kolanovic mentioned something similar in his latest note, while documenting what could prompt the “unprecedented divergence” between value/cyclical stocks and low volatility/defensive stocks to close. “Stabilization of economic numbers [or] progress in the trade war would help”, Marko wrote.
The upshot is that a swing back towards a regime characterized by better-than-expected growth outcomes would have dramatic consequences in an environment where performance and risk appetite have been driven by expectations of monetary policy largesse predicated on slumping global growth.
In a note dated Wednesday, Goldman touches on all of this, drawing a connection with 2016.
“Expectations for easier monetary policy built up throughout the year, first into the dovish pivot from the Fed at the beginning of the year, followed by a second dovish wave post ECB President Draghi’s Sintra speech and the June FOMC meeting”, the bank writes, adding that “the same was the case in 1H 2016 but, after the Brexit referendum shock on June 23, ‘global growth’ expectations eventually picked up, further boosted by the election of US President Trump in 3Q, which drove a large procyclical rotation across and within assets (S&P 500 was up 15%, US 10-year yields rose by 130bp, gold declined by 18%, and the Yen fell by 15%)”.
Could we be in for another rotation? Maybe. The bank notes that global growth expectations have shown some signs of life lately and there are nascent signs of a procyclical bent taking hold, although Wednesday’s PMIs out of Europe certainly don’t help the case.
Goldman goes on to say that how things evolve will depend heavily on the interaction of monetary policy and growth outcomes. That’s always the case, but consider it in the context of everything said above. The bank delineates four cross-asset regimes using combined changes in the expectation for ‘global growth’ and ‘monetary policy’ (based on Principal Component Analysis of their Risk Appetite Indicator). Those four regimes are:
- Central bank put: easier monetary policy expectations in response to weaker growth,
- Goldilocks: easier monetary policy despite better growth,
- Reflation: tighter monetary policy with better growth, and
- Balanced Bear: tighter monetary policy despite weaker growth
Obviously, 2018 was a brush with the “balanced bear”, as the Fed kept tightening even as global growth outcomes deteriorated (and don’t place all of the blame for that on Jerome Powell – remember, the US was running pro-cyclical fiscal policy alongside protectionist trade policies, which together can be an inflationary mix).
After starting 2019 squarely in “central bank put” territory, Goldman says that in Q2 “there was a shift… to a mini ‘Goldilocks’ setup with easy policy and improving growth expectations”.
So, if we’re in “mini-Goldilocks”, what’s the risk? Well, if you’ve been following along, the answer to that question should be clear.
“Continued improvement in growth increases the risk of disappointments from central banks eventually”, Goldman cautions, echoing the assessment of Nomura’s McElligott.
The bank goes on to say that while a Fed cut this month is a slam dunk (90% on their subjective probabilities), another cut in September is “far from a done deal in the event of better US growth due to very easy financial conditions”. (Their base line is still for a 25bp cut in September following a move in July.)
All in all, Goldman warns that “after a switching between ‘central bank put’ and ‘Goldilocks’ for most of 2019, the risk of a transition to ‘reflation’ or ‘balanced bear’ has increased”.
Both of those regimes are potentially precarious, with the latter especially so, but even in a benign situation, a transition out of “central bank put” and/or “Goldilocks” and into either “reflation” or balanced bear” would usher in meaningful rotations with the potential to catch lopsided positioning woefully offsides.