Need-to-knows: 3 key charts for for 2018
2017 was a stellar year for the main asset classes, as the cyclical recovery in the aftermath of the growth scares in 2015-16 gathered pace, while inflation stayed subdued. As an inevitable consequence, monetary conditions are beginning to tighten, bringing the era of cheap money to an end. What does this mean for 2018? For now, the degree of tightening is not enough to dampen global growth and derail the rally in risk assets. Later in 2018, neither the economy nor markets will be able to defy gravity completely. Monetary headwinds are gathering pace as the Fed is reversing the biggest experiment in recent monetary history, which will cause higher volatility and lower returns compared to 2017. Finally, watch out for a potential peak in equities in the second half of 2018. This normally requires two conditions to be met: An inversion of the yield curve and bottoming credit spreads.
What is “Professor Curve” telling us about 2018, recession risks and market peaks?
The US yield curve flattened considerably in 2017. This has garnered a lot of attention, as the yield curve is one of the market’s favourite recession indicators. An inverted yield curve normally signals a US recession. And as we know, equity bull markets do not die of old age but rather because the US enters a recession. We are still roughly 60 basis points away from an inversion (see Figure 1). At the time of this writing, recession risks are low, but rising according to Professor Curve.
If the yield curve is not signalling a recession, then why worry, one might ask? Figure 1 tells the story. The yield curve flattening reflects tighter monetary conditions. Short-term rates have risen (proxy for financing costs), while long-term rates (proxy for potential returns) have stayed rangebound. Therefore, the yield curve signals a turning credit cycle, reflected in lower loan demand going forward. Unless Mr. Trump’s tax cuts manage to reverse this trend, the credit cycle points towards lower growth in 2018 and 2019. As an aside, it’s worth noting that the flattening so far is for real and not some form of data quirk, as it is completely in line with the broader cyclical picture.