This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
We saw the best of all macro environments last year – with global growth accelerating and inflation undershooting expectations. This ‘goldilocks’ outcome enabled strong earnings and kept central banks dovish, while ensuring low volatility.
However, goldilocks was a story for last year. Macro dynamics are now turning upside down as the growth/inflation trade-off deteriorates. While 2017 was a year of accelerating growth and falling inflation, 2018 is seemingly being shaped by the opposite – slowing growth and rising inflation.
Although structural factors are keeping a lid on inflation in the long term, the risk of a near term overshoot is rising. At the same time, global growth is peaking and showing signs of slowing as monetary tightening hits real growth with delay.
What does this mean? We believe markets could soon be hit by a potential double whammy of disappointing growth and tighter monetary policy. The combination of less buoyant growth and hawkish central banks is a recipe for higher volatility and lower risk-adjusted returns. Macro trends are increasingly being questioned, while correction risks stay high and most assets are expensive.
Therefore, liquid alternatives with low correlations to overall markets should be in focus over the coming quarters. If Trump’s tax cuts were to result in a hiring spree, wage pressures would cause the Fed to tighten even more, ultimately ending in stagflation tears.
The Beginning of the End
This market correction might not mark the peak in equities, but should mean the start of a topping process. The end-of-cycle roadmap travels via a bottoming of credit spreads and a yield curve inversion, through to a passing of the peak in equities and ultimately ends in a recession.
Markets might have passed the first milestone. While showing no signs of panic, credit underperformed in the first quarter of 2018, confirming our negative view on the asset class. Spreads are showing signs of bottoming out and high yield defaults should rise as the credit cycle turns.
The second milestone could be passed later in 2018. Further flattening and inversion of the US yield curve in the second half of this year is on the cards. This is consistent with a deteriorating growth/inflation trade-off, as central banks’ inflation alertness could make the long end of the curve reflect rising downturn risk.
Although late-cycle signals are flashing amber, the consensus is still obsessed with an undeniably strong macro backdrop. But is it a given the macro can drive the markets? This is where today’s extreme valuations come into play. Cyclically adjusted price-earnings ratios for US equities dating back to 1881 have only been higher during the dotcom bubble. If valuation is added to traditional yield curve-based recession models, the probability of a US recession rises above critical levels. We expect equities to peak this year as the above milestones should be reached. The ‘big top’ is within reach.
What could extend the life of the ageing bull? First, the right kind of falling inflation – for example, slower wage growth or rising productivity – would mitigate the risks described above. This would temper the tightening appetite of central bank and keep the profit cycle running.
Secondly, a repeat of last year’s US dollar weakness would cheapen funding for a world awash with debt, making the Fed’s tightening more digestible. Absent this, investors should play it safe, preparing portfolios for a rougher ride ahead. Limiting correlation and liquidity risks is key when the big top is within sight.
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