Need-to-knows for Q2: 3 key charts…
…and 3 key questions to ask
Bonds outperforming equities in the first months of 2018 as surprise for most investors as the year got off to a turbulent start. This marks the end of the low volatility era in our view. The 2017-goldilocks set-up is challenged by a changing macro mix: The growth/inflation trade-off is deteriorating. Inevitably, the US central bank will continue tightening and growth will disappoint. This late-cycle macro backdrop is setting the stage for lower risk adjusted returns, confirming our 2018 outlook. We might not have passed the “big top” in equities yet, but February’s equity drawdown is likely to be the start of a topping process. The late cycle clock is ticking.
Lessons from Q1: What is February’s market correction signalling for 2018
First, the recent correction marks the end of the low volatility regime. The NY Fed chief Dudley labelled February’s market turmoil “small potatoes”. The comment carries an important message: The US central bank is happy with a correction. Consequently, the Fed is likely staying on its tightening course, not back-stopping the market anymore. Why is this important? Because central bank tightening pushed volatility up to begin with. As monetary tightening is here to stay, so is higher volatility, pointing towards lower risk adjusted returns across most asset classes in 2018.
Secondly, the correction tells us something about the pain threshold in rates and the underlying strength of the economy. High growth potential implies a high pain threshold and vice versa. In February, correlations between yields and equities turned negative. In contrast to large parts of 2017, higher rates went hand-in-hand with falling equities (figure 1), signalling that we might be close to the pain threshold, despite real and nominal rates still being low in a historical context.
A low interest rate pain threshold is a strong indication that the low growth environment is prevailing. Seen from this perspective, the low rates environment has staying power as any spike higher will cause market turmoil and growth to slow, pulling rates lower again: A self-correcting mechanism. Long-term interest rates should not rise much from here. With valuations far more attractive than a few months ago, investment opportunities emerge in the core fixed income space.
Third, markets are becoming jittery around inflation risks. Rising yields since December were driven by a rising term premium. This is key as the latter is by-and-large reflecting a higher inflation risk premium, i.e. the risk of inflation overshooting. We are not believers of an escape from the low inflation environment. Nevertheless, a cyclical uptick should be expected in the coming months, likely to keep investors on their toes. Trumps tax cuts are adding to inflation jitters. The US economy is firing on all cylinders. More stimulus would favour wage rises over real growth. With these risks on the radar, low duration products should continue to be en vogue. The good news: Short-term real rates are now offering positive returns without moving out the risk spectrum. As volatility and safe haven demand rises, allocation to low duration high rated bonds is superior to simply holding cash.
Figure 1: The interest rates close to the speed limit