Autumn outlook: Disruptive divergence

The global economy is caught in an asymmetric slowdown, with the US outperforming the rest of the world. The result is a double whammy of monetary tightening via higher interest rates and US Dollar appreciation. Ultimately, this disruptive divergence creates an unstable equilibrium: Either the US has to slow or China and the rest of the world need to accelerate. For now, we believe divergence is here to stay, as Dollar strength in itself reinforces this theme by hurting regions outside the US the most. Further down the road, the path of least resistance is slower US growth, as the headwinds to Chinese growth seem to have more staying power than the tailwinds of the US economy. Meanwhile, the big top in equities is getting closer. The almighty US Dollar is key: If the Greenback appreciates further form here, it should tighten monetary conditions enough to trigger a big top within the next six months. In light of rising macro risks, defensive sectors and regions should outperform within equities and safe havens increasingly be sought after.


Diverging outlooks: Stronger US growth comes at a cost

The macro narrative has changed from “synchronised recovery” in 2017 to asymmetric slowdown in 2018. We believe the global economy passed “peak growth” in H1 2018 as a result of a double whammy of monetary headwinds: Rising US short-term real rates (despite higher inflation) and a stronger US Dollar. These headwinds are slowly but surely gathering pace as inflation in the west is ticking up, confirming our view of a less favourable growth/inflation trade-off. In July, US core inflation hit the highest levels since the financial crisis.


A key driver behind the monetary tightening is a disruptive divergence between the major economies (see charts below). On the one hand, US growth is holding up well, enjoying the cyclical tail winds from Trump’s tax cuts. China is on the other end of the scale. Its economy is slowing as a result of reduced credit flows and the asymmetric pain protectionism imposes on the global economy. The US is the relative winner of the ongoing US – Sino trade conflict, as its economy is large and relatively closed. China, on the other hand, being one of the main winners of past decade’s globalisation, is bearing the brunt of the pain.

Diverging outlooks: The global economy is increasingly firing on one cylinder

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This divergence naturally creates frictions in the market space with FX being the main “disruption channel”. More concretely, it translates into USD strength (see LHS chart below). A strong Greenback amounts to additional monetary tightening primarily outside the US and in Emerging Markets (EM) in particular, where a lot of Dollar-denominated debt has been generated. A stronger Dollar thus means higher debt servicing costs for EM countries. The risk is a disruptive feedback loop between individual markets and the overall economy: Macro divergence creates US Dollar strength, which hits EM the most (see RHS graph below); this further boosts macro divergence, which results in more US Dollar strength and so on.

An unstable equilibrium: Will the US slow or will the rest of the world accelerate?

The markets are rewarding the US for its macro outperformance, with global equities ex-US being down year-to-date. Emerging Markets, on the other hand, are being punished. But the disruptive divergence theme ultimately creates an unstable equilibrium. To some extent, US outperformance comes at the cost of lower growth outside the US, where tighter monetary conditions are the side effect of relative US strength. Thus, something will have to give at some point – either the rest of the world will accelerate or the US will slow. The first scenario will be risk-on, the latter risk-off. The drivers behind US strength are mostly cyclical (tax cuts, higher oil prices), while the sources of China’s weakness (financial rebalancing needs, protectionism driven by a low wage share in the west) seem more structural in nature and, therefore, persistent. Bottom line: The US is more likely to adjust down rather than China and the rest of the world catching up. This, however, might be a story for 2019. For now, disruptive divergence is setting the macro scene.

Disruptive divergence: Macro divergence means US Dollar strength, resulting in tighter monetary conditions and EM pain

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What does disruptive divergence mean for the market place?

Disruptive divergence and tightening global liquidity means that the most crowded trades from 2017 are falling like dominoes in 2018: Starting with low Vol strategies collapsing in February, continuing with short USD trade failing and emerging markets reversing last year’s outperformance. Which areas will be the next to feel the pain of tighter liquidity? We think low-rated credit segments and ultimately the long equity trade. So when will equities finally peak? Again, the USD is key in our view due to its impact on monetary conditions: A further 5% appreciation of the trade weighted USD before year end would probably mean sufficient monetary tightening to cause a “big top” in equities within the next six months (LHS chart below). Meanwhile, investors should stay defensive within equities (RHS chart below). Developed markets (US in particular) are expected to continue their outperformance as these countries are less vulnerable to slowing growth and tighter liquidity. Rising macro risks also imply that the value proposition of core fixed income in Europe and the US is looking attractive, as protectionism and monetary tightening ultimately are deflationary factors. Safe havens and high-rated short-duration bonds should increasingly be sought after as existing macro trends are being questioned and the big top is in sight. Especially covered bonds stand out, as they can provide similar yields and lower risk as compared to IG bonds.

What could be a positive circuit breaker? As monetary conditions are key, central banks naturally take centre stage. A dovish reversal of the Fed or full-Monty stimulus from the Chinese central bank are obvious candidates, but economic pain probably has to get considerably worse to make central banks turn around. Trump becoming less hawkish on trade is less likely, in our view. Given that China’s rise has gone hand-in-hand with a falling wage share of US workers; he potentially will hit two birds with one stone by playing hard-ball with China: A hawkish trade policy increases America’s chance to stay at the helm of the global economy and it satisfies his electorate.

Big top in equities in sight as Dollar tightens global monetary conditions. Meanwhile, growth rolling over favours defensive sectors.

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Note: This is a NAM macro view, not the official Nordea view

About Nordea Asset Management

Nordea Asset Management (NAM, AuM 213.4 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 307 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., 30.06.2018

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@Nordea Asset Management

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