2017 H2 Outlook: An impossible trinity

Senior macro strategist Witold Bahrke answers key questions

1. Reflation hopes dominated the macro narrative in H1, but inflation recently has weakened. Will reflation hopes get a revival in H2 or is it back to the “lowflation” norm?

While the first half of 2017 was very much about reflation hopes, i.e. expectations of higher growth and moderately higher inflation, we expect a “post reflation” narrative to dominate the second half of 2017. Inflation has weakened recently, confirming our “peak reflation” thesis in the Q2 outlook. In both the US and Europe inflation is expected to stay below central banks’ target of around 2%. At the same time, our growth indicator is pointing towards a “down to earth” scenario in H2. It has been ticking down for a while (see chart), signalling a cyclical turning point in H2. This reflects a slowing in Chinese growth as the PBoC seeks to limit leverage risks as well as disappointing US growth amid Trumponomics that thus far has failed to generate any traction. Europe remains the bright spot, showing no signs of slowing momentum. Overall, we expect a disappointing economic outcome in H2, which also should be reflected in weaker than expected earnings growth. Reflation remains a bump, not a paradigm shift.

Graph 1

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Graph 2

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2. Recently, markets have become increasingly sensitive to central bank signals. Is that a taster of what to expect in H2?

Markets are right to be worried about central banks. As the economic backdrop is one of high but slowing growth and weak inflation, you wouldn’t expect central bankers to tighten. But this is exactly what is happening. The major central banks are sending hawkish signals. The Fed is preparing the ground for a balance sheet reduction, entering the unchartered territory of quantitative tightening. There are good reasons to do so in order to limit financial risks in light of high valuations and very low investor fear. But this is also a giant experiment. We haven’t been here before and nobody knows what the potential effects may be. Nevertheless, the bottom line is that one of the most important drivers behind many asset classes is losing its punch as liquidity growth slows. In other words, the market will increasingly have to search for new drivers to take over. Given the weak macro backdrop described above, it is questionable how successful that search will be over the coming months.

Graph 3

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Graph 4

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 3. An environment of combined weak inflation, slowing growth and tightening of central banks sounds challenging. How will this affect markets in H2?

A weakening economic backdrop, tightening central banks and rich asset prices is an impossible trinity, in our view. Maximum 2 out of these 3 factors are likely to prevail towards year end. As the economic signals are consistently pointing towards lowflation, the key question for H2 therefore is who will blink first: a frothy Mr. Market becoming more risk averse or hawkish central bankers turning more dovish? We think Markets will be first to blink with risk aversion increasing in H2, as central bankers, almost by nature, only adjust course very gradually. Flip-flopping between hawkishness and dovishness means less central bank credibility going forward, and credibility is a treasured good for central banks – hard to earn, easy to lose.

This means that high valuations across many assets classes will increasingly be questioned given an uncertain macro backdrop and a less clear central bank “put”, i.e. protection.

So the impossible trinity needs a resolution, and the likely outcome is higher volatility and a less risk-friendly H2. Ultimately central banks might be forced to blink, as well, and remove their hawkish bias at least for a while, as they can’t ignore the weak inflation backdrop forever. This might happen in Q3, limiting the downside in risk assets. 

About Nordea Asset Management

Nordea Asset Management (NAM, AuM 219 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 332 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients.  NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 30.06.2017

 

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