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


A changing macro mix: is Goldilocks gone?

Last year saw the best of all macro environments: Global growth accelerated and inflation undershot expectations. This macro environment secured strong earnings while keeping dovish central banks at bay and volatility low. The outcome: goldilocks as we know it.

But goldilocks was a 2017 story. Macro dynamics are turning upside down in 2018 as the growth/inflation trade-off deteriorates. While 2017 was a year of accelerating growth and falling inflation (see figure 2), 2018 seems to be shaped by the opposite: Slowing growth and rising inflation. Although structural factors are keeping a lid on inflation in the long term, the risk of a near term overshoot is rising. At the same time, global growth is peaking and showing signs of slowing as monetary tightening hits real growth with delay. So far, our macro call for 2018 is therefore on track.

Figure 2: A changing macro regime in 2018


This means markets could be hit by a potential double whammy of disappointing growth and tighter monetary policy.  Less buoyant growth and hawkish central banks is a recipe for higher volatility and low risk adjusted returns. Macro trends are increasingly being questioned. Correction risks stay high and most assets are expensive. Liquid alternatives with low correlations to overall markets should therefore be in focus over the coming quarters. If Trump’s tax cuts were to result in a hiring spree, wage pressures would cause the Fed to tighten even more, ultimately ending in stagflation tears.

How far are we from the big top? An alternative perspective on recession risks. 

The market correction might not mark the peak in equities, but should mean the start of a topping process. The end-of-cycle roadmap goes via bottoming credit spreads and a yield curve inversion, then passing the peak in equities and ultimately ending in a Recession.

Markets might have passed the first milestone. While showing no signs of panic, credit has underperformed in Q1, confirming our negative view on the asset class. Spreads are showing signs of bottoming out and high yield defaults should rise as the credit cycle turns. The second milestone could be passed later in 2018. Further flattening and inversion of the US yield curve in H2 is in the cards. This is consistent with a deteriorating growth/inflation trade-off, as central banks inflation alertness could make the long end of the curve reflect rising downturn risk.

Although late-cycle signals are flashing amber, the consensus is still obsessed with an undeniably strong macro backdrop. But can it be taken as a given that causality runs from macro to markets? We think extreme valuations can make causality turn around. In that case markets become the key risk for the macro outlook instead of strong macro keeping an ageing bull alive. Cyclically adjusted price-earnings ratios for US equities dating back to 1881 have only been higher during the dotcom bubble.  The graph below illustrates the implication. If valuation is added to traditional yield curve based recession models, the probability of a US recession rises above critical levels. We expect equities to peak this year as the above milestones should be reached. The big top is within reach.

What could extend the life of an ageing bull? First, the right kind of falling inflation ( i.e. slower wage growth or rising productivity)  would mitigate the risks described above, tempering central banks’ tightening appetite and keeping the profit cycle running. Secondly, a repeat of last year’s US dollar weakness would cheapen funding for a world awash with debt, making the Fed’s tightening more digestible. Absent this, investors should play it safe, preparing portfolios for a rougher ride ahead. Limiting correlation and liquidity risks is key when the big top is within sight.

Figure 3: Alternative perspectives on recession probabilities


Source:  Nordea Investment Management AB and Macrobond

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

About Nordea Asset Management
Nordea Asset Management (NAM, AuM 223.6 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 330.4 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., 25.01.2018

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