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.

Figure 1

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A final word on recession risks and therefore risk of a peak in equities: as previously mentioned , normally an inverted yield curve signals a recession in the not too distant future. The signal becomes even stronger if credit spreads have also reached a cyclical trough. While there are signs that high yield spreads could have reached their nadir, the question is when the yield curve could invert. As inflation and potential growth are likely to stay low in the medium term, we think there is very limited room for long-term rates to move up in the US—hence, we reiterate our long held view that the curve will flatten further. This also means that a potential yield curve inversion becomes a question of how much the Fed will hike and therefore push up short-term rates.

While we think the Fed is unlikely to hike three times in 2018, as its own expectations are currently indicating, two hikes might be enough to invert the curve once we move into the second half of 2018. If history is any guide, this would point towards a recession early 2019 and a peak in equities in Q3 or Q4 next year. This context also illustrates why significant tax cuts in the US might create a short-term gain, but long-term pain. Significant stimulus would most likely force the Fed to hike even more than three times, which in our view would bring forward an inverted yield curve and a US recession. While this is a downside risk, the bull market could get another boost if an inversion were to be met by renewed Fed easing, re-steepening the curve and fending off recession risks.

A word of caution: The time lag between yield curve inversion, credit spread troughs and recession vary considerably, hence it is notoriously difficult to call “the big top” in equities. Inversion or not, from an investor perspective the time is ripe to scale down exposure in markets that are most vulnerable to tighter monetary conditions, a turning credit cycle and a flatter yield curve. High yield might be the first to come under pressure under these conditions. Equities should still show decent returns until monetary tightening begins to bite in the real economy, which might be a second half story. Consequently, we currently prefer investment grade corporate bonds over lower rated segments.

Get ready for the coming cycle of rising volatility
As mentioned above, a flatter yield curve in essence reflects monetary tightening. This eventually causes the credit cycle to turn. The exceptional loose monetary conditions since the Great Financial Crisis have been a precondition for low volatility in markets and the economy. Since the monetary tide is turning, we expect volatility to make higher highs and higher lows in 2018. Again, the yield curve helps illustrate this point, as a flattening of the curve, and hence tighter monetary conditions, should increase volatility across asset classes (see figure 2).

Figure 2

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In essence, a flattening yield curve and rising volatility reflects the late stage of the business cycle. In itself, this means that existing macro trends are increasingly being questioned. This calls for alternative investment strategies that are agile and that limit the impact or even benefit from potential trend reversals. Liquid alternatives come into focus. They provide diversification through low correlation with the overall market. If combined with a risk premia-based investment approach, they can even offer new sources of returns in times where rich valuations indicate low expected returns across traditional asset classes.

Feeling good: What high confidence levels mean for future returns
The cyclical recovery that took hold in early 2016 and has run full steam ahead ever since has resulted in extremely high readings of economic confidence across the globe. One example is the Euro Area business sentiment index (shown in figure 3). While elevated confidence confirms the cyclical strength, it also is a typical late cycle phenomenon, as it normally occurs a few quarters before the business cycle rolls over. A key reason for this goes back to one of our main points for the 2018 outlook: The robust health of the recovery is forcing central banks to scale back stimulus and eventually tighten. The US Fed is clearly ahead of the curve in this process.

It could be even be more important in this cycle as compared to previous episodes as monetary stimulus arguably has been the most important driver for both markets and the economy ever since the financial crisis. A removal or even reversal of this driving force is decisive, to say the least. While the very elevated confidence levels do not contradict further upside in risk assets in the coming months or even quarters, it does mean that downside risks are rising in the medium term. Hence, it might be a good time to book profits areas of the market that have run red hot in 2017.

No doubt, as long as confidence continues to rise investors are home free. But as soon as a downward trend crystalizes, caution is warranted. Case in point: The asset return cycle, measuring risk asset performance against safer assets, is typically in the process of peaking in phases when the broad thinking is that nothing can go wrong.

Figure 3
(Note: This is NAM macro view, not the official Nordea view)

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About Nordea Asset Management
Nordea Asset Management (NAM, AuM 221.5 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 330.9 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., 30.09.2017

Nordea Asset Management is the functional name of the asset management business conducted by the legal entities Nordea Investment Funds S.A., Nordea Funds Ltd and Nordea Investment Management AB (“the Legal Entities”) and their branches, subsidiaries and affiliated companies. This document is intended to provide the reader with information on Nordea’s specific capabilities. This document (or any views or opinions expressed in this document) does not amount to an investment advice nor does it constitute a recommendation to invest in any financial product, investment structure or instrument, to enter into or unwind any transaction or to participate in any particular trading strategy. This document is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instruments or to participate to any such trading strategy. Any such offering may be made only by an Offering Memorandum, or any similar contractual arrangement. Consequently, the information contained herein will be superseded in its entirety by such Offering Memorandum or contractual arrangement in its final form. Any investment decision should therefore only be based on the final legal documentation, without limitation and if applicable, Offering Memorandum, contractual arrangement, any relevant prospectus and the latest key investor information document (where applicable) relating to the investment. The appropriateness of an investment or strategy will depend on an investor’s full circumstances and objectives. Nordea Investment Management recommends that investors independently evaluate particular investments and strategies as well as encourages investors to seek the advice of independent financial advisors when deemed relevant by the investor. Any products, securities, instruments or strategies discussed in this document may not be suitable for all investors. This document contains information which has been taken from a number of sources. While the information herein is considered to be correct, no representation or warranty can be given on the ultimate accuracy or completeness of such information and investors may use further sources to form a well-informed investment decision. Prospective investors or counterparties should discuss with their professional tax, legal, accounting and other adviser(s) with regards to the potential effect of any investment that they may enter into, including the possible risks and benefits of such investment. Prospective investors or counterparties should also fully understand the potential investment and ascertain that they have made an independent assessment of the appropriateness of such potential investment, based solely on their own intentions and ambitions. Investments in derivative and foreign exchange related transactions may be subject to significant fluctuations which may affect the value of an investment. Investments in Emerging Markets involve a higher element of risk. The value of the investment can greatly fluctuate and cannot be ensured. Investments in equity and debt instruments issued by banks could bear the risk of being subject to the bail-in mechanism (meaning that equity and debt instruments could be written down in order to ensure that most unsecured creditors of an institution bear appropriate losses) as foreseen in EU Directive 2014/59/EU. Published and created by the Legal Entities adherent to Nordea Asset Management. The Legal Entities are licensed and supervised by the Financial Supervisory Authority in Sweden, Finland and Luxembourg respectively. The Legal Entities’ branches, subsidiaries and affiliated companies are licensed as well as regulated by their local financial supervisory authority in their respective country of domiciliation. Source (unless otherwise stated): Nordea Investment Fund, S.A. Unless otherwise stated, all views expressed are those of the Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and affiliated companies. This document may not be reproduced or circulated without prior permission. Reference to companies or other investments mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. The level of tax benefits and liabilities will depend on individual circumstances and may be subject to change in the future. © The Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and/or affiliated companies.

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