The news that will drive asset returns
(This is the second and final part our flagship report on noise in the markets, please find the first part here)
I am not going to walk you through my rationale on why I believe long date rates and inflation are peaking. Regular readers are up to speed on my disinflationary views and thinking regarding the re-rating of emerging market assets over the course of the next several years. However, I do want to give you a quick summary on the news items that I believe are not noise but true drivers of asset returns:
- The outlook for inflation and Fed policy - the tightening cycle by Fed Chair Powell looks well established and it would take a violent correction in risky assets, driven by credit widening, for the Fed to deviate from the trajectory of a rate hike every three months. As a client said to me last week, we are only a 20% equity correction and a 500-basis point widening in credit away from a recession, but the chances of this are very remote. While I do believe growth and inflation are peaking around the globe, the Fed will remain on course for June and the market should fully price a September hike in relatively short order. The curve will continue to flatten, and I suspect we will see 2’s / 10’s inversion by Q4. This isn’t a predictor of recession even though there are certainly negative consequences for bank lending. Yield curve inversion is more about a lack of quality long term yielding assets than a precursor of negative growth.
- The outlook for European growth – Weather related or something more serious? The slow down in European activity has been pronounced and should be of a concern. The rebound in European equity has more to do with a 4% weakening in the Euro than any statement about the value of European equity but it has clearly helped. It is difficult for me to see how European growth continues to struggle with cash rates negative and certainly below neutral. Recessions just don’t occur when cash rates are significantly below neutral, so I would expect a rebound in activity as we head to the second half of 2018.
- China’s policy response to a mild slow down and tariff – China is beginning to ease policy. The RRR cut and more importantly, the reluctance of regulators to implement the deleveraging policies targeting off balance sheet / shadow banking / wealth management product is a sign that Beijing wants to maintain growth that has, at the margin, come off the boil. PPI and CPI are rolling over, mostly due to the base effects of last year’s efforts to boost industrial prices. The services sector is also seeing growth rates slowing. Throw in concerns about the impact of US tariffs on Chinese goods and the outlook for stimulus, both monetary and fiscal, is incredibly constructive. This is the classic example of noise versus concrete action. The noise around the trade issue creates short term gyrations where the true driver of asset returns in China will revolve around any stimulus that is initiated in response to a potential economic slowdown. With this backstop, the outlook for Chinese assets is very rosy.
- Earnings – A fantastic US earnings season that was swamped by noise. While this should provide valuation support for a myriad of sectors, we have probably seen the peak for US earnings growth for 2018. The tax cuts were a “sugar high” for US corporates and this will make comparisons difficult going forward. That said, the growth environment remains solid for the US and my long-term outlook for improving productivity bodes well for profit margins. Globally, earnings should continue to be supportive for EM and DM equities.
We all battle noise on a daily basis. Distinguishing between noise and true fundamental drivers of asset returns is going to get more difficult for the next few months as the level and amplitude of the cross currents grows and grows. Now you may disagree with my long-term narrative that inflation isn’t going to be a problem; that long dated yields are capped and that we are in the early stages of a multi-year re-rating of emerging market assets. What I am saying is that noise creates opportunities and it always will. If you are bearish on EM because you think the USD has bottomed, do not dump EM equity on the back of bad China / Taiwan headlines (these are coming!). Don’t hit bids if Syrian tensions get worse. Will Argentina lead to EM contagion? Be smart. Appreciate that noise is not narrative and history tells you that selling pressures (or buying pressures for that matter) quickly reverse when the dust settles and the headlines fade. Stick to your fundamental thinking and don’t be fooled into believing that noise is the start of something bigger.
Founder, View from the Peak
IND-X Advisors Limited