Economic analysis has been of little help to predict markets in the past 10 years, because Central banks interventions heavily distorted market prices, blatantly disconnecting them from economic reality.....
By Didier Saint Georges, Managing Director and member of the investment committ
In 2018, the reduction in liquidity supply by the same central banks should normally make economic predictions more meaningful for markets. However, in the meantime the world has changed, and economic analysis might well prove misleading again.
Digital growth is unquestionably creating value, and economists’ tools are still very much struggling to measure it. They can quantify plants and equipment, but do not know how to deal with databases or cloud computing. So that investment and GDP numbers are certainly understated. Not to mention that the puzzle of “growth recovery without inflation”, which is so perplexing for economists and bond markets, would also be better understood if economists undertook a proper delving into the deflationary effects of new technologies. So, if economists’ input definitely still needs to be taken with a pinch of salt, what could we base a vision of 2018 financial markets on?
Mild global slowdown driven by US economy: over-weight in European, Emerging market equities, and high quality and high visibility growth stocks
First, whatever the exact numbers, there is no question that the economic world is progressively healing from the wounds of the great financial crisis. The US economy has already evidenced its capacity to keep progressing with less monetary support. And the momentum currently evidenced in Europe, Emerging markets, or Japan is making it plausible that these economies will also be able to weather slightly less accommodative financial conditions next year.
It is also plausible that, irrespective of the upcoming tax reform, the US economic cycle is about to show signs of fatigue, while other regions, which turned up later than the US are showing stronger dynamics.
Therefore, the central scenario on which we would be tempted to hang our hats would be one of a mild global slowdown, driven by the US economy. Such a backdrop justifies to remain over-weighted in European and Emerging market equities, and over-weighted in high quality and high visibility growth stocks, rather than value or cyclical stocks.
Low risks on bond markets
Bond markets certainly are where Central banks’ price distortions have been the greatest, in both the credit and sovereign areas, particularly in Europe. Therefore, with the exception of some sub-sector pockets, like European banks subordinates, structured credit or some Emerging market sovereigns such as Mexican local debt, we would very much keep our risk profile quite low on bond markets.
Main uncertainty for markets in 2018 not stemming from economy, but from their technical fragility
Passive funds, risk-parity funds have all been accumulating massive investment assets on the assumption that volatility would remain heavily compressed, as it has been over the past several years. They might be right. But several unknowns could also make this volatility spike, such as fears about a return of protectionist claims, disruptions in the oil market, geopolitical tension, monetary policy mistakes, not to mention a weaker economic cycle, a resurgence of inflation, or simply the urge of profit taking. With markets priced to perfection, and momentum investing at its high, one needs to be cognizant of the asymmetric risks of both fixed-income and equity markets at these levels. This could well usher in a major come-back of risk management as a key performance tool in 2018.