- The global expansion should remain intact for 2018, though the near-perfect backdrop could deteriorate.
- The probability of a US recession is low, despite the maturing business cycle.
- As policymakers reduce monetary accommodation, inflation and market volatility could rise.
- To guard against the increasing uncertainty of outcomes in 2018, limit cyclical tilts and prioritize diversification.
The year 2017 has been defined by a near-perfect combination of steady global growth, low inflation, and accommodative monetary policies. All major asset categories have experienced positive returns, and US and global equity markets have registered stellar double-digit gains. Most notably, this all happened alongside plunging financial asset price volatility, with the S&P 500 Index experiencing no calendar month of negative returns in 2017 and only one in the past 21 months.
While easy global monetary conditions spurred robust liquidity growth and likely helped dampen asset price fluctuations, economic fundamentals such as growth and inflation also registered surprisingly steady trends and falling volatility (see chart, right). In 2018, we expect some fraying in this picture-perfect backdrop that could raise volatility from extremely subdued levels.
Growth outlook: Synchronized global expansion continues
In 2017, almost all of the world's major economies were in some phase of expansion, leading to a self-reinforcing global acceleration and the most synchronized global up-turn in at least several years (see chart, below). The primary driver of the pickup in global activity was China's reacceleration over the past 18 months, which catalyzed a turnaround in global industrial production, exports, commodity industries, and the profits of multinational corporations.
As we look into 2018, there are signs that China’s policymakers are already removing stimulus from the economy, and it appears they may be more focused on addressing structural issues after Xi Jinping's power consolidation during October's National Party Congress.
- Policymakers are attempting to rein in China's credit boom and rapid increase in debt by tightening shadow financing (loans from non-bank, unregulated entities), and allowing short-term interest rates to rise. This has already resulted in credit growth falling to its lowest rate in almost a decade (see chart, right).
- Efforts have been made to restrain production in areas of overcapacity, including tighter restrictions on highly polluting industries such as steel, coal, and cement, as well as policies to slow construction in housing and infrastructure.
Because China's business cycle is often driven more by state policy than private market indicators, the directional shift away from policy easing carries risks for its near-term growth outlook. Not only do we expect China's 2018 performance to be more uncertain, but it also contains significant downside risks for global activity given its outsized influence on global trade, manufacturing, and commodities.
The US has remained on a very gradual progression through its business cycle, with mid-cycle dynamics remaining solid throughout 2017 and just a few hints of late-cycle trends along the way. Odds of recession are relatively low given today’s tight labor market and broad-based expansion. We will be watching these key indicators that historically have marked the transition from the mid- to the late-cycle phase (see chart, below):
- Typically during a late-cycle phase, corporate profit growth decelerates and inventories build relative to new orders. So far, low inflation and robust global growth have supported a pickup in company profits and new orders in manufacturing.
- Wage growth usually accelerates during the late-cycle phase and starts to crimp profit margins and slow the pace of hiring. This cycle, wages have risen and profit margins have declined off peak levels, but the process has been gradual, allowing margins to remain high and job gains strong.
- Historically, rising wages lead to broader inflationary pressures, causing the Federal Reserve to tighten monetary policy, which in the late cycle tends to lead to a flattening yield curve and tighter credit conditions.
This time, wages have risen moderately but inflation is low. The Fed has hiked rates and the yield curve has become flatter, but it remains relatively steep and credit conditions remain supportive.
Summary of global growth outlook:
- Less-supportive economic policies in China make the out-look more uncertain and a growth deceleration probable.
- Global activity has likely peaked and growth may slow in 2018.
- Today's US recession probability remains low, but we expect the economy to continue its slow transition from the mid- to late-cycle phase.
Inflation outlook: Global inflation firm, with upside risk
The biggest surprise to us in 2017 was that the acceleration in global growth did not spur a bigger pickup in inflation. Nevertheless, there is evidence that global inflation trends have firmed:
- Purchasing manager surveys in almost all of the world's largest economies have reported rising prices paid and received, indicating firmer inflation in global goods.
- Core inflation in the eurozone has been on a steady rise during the past year, and we expect continued above-trend growth to keep this trend intact.
- Japan might be seeing early signs that tight labor markets are finally pushing core inflation toward a positive medium-term trend.
- Dissipating slack is pushing US labor markets close to full employment, which should provide an upward bias to wages.
- Oil prices climbed to 2-year highs, and even if they don't rise further, will start to add to headline inflation rates.
There are many reasons inflation has remained low—automation, globalization, the entrance of oligopolies into new industries, cheap funding for unprofitable companies—and it's likely they will continue to put a ceiling on price pressures. While we don't expect a jump to much higher inflation in 2018, global inflation appears firm and there are upside risks given low investor expectations for price increases.
Monetary policy outlook: Move toward normalization to spur higher market volatility
We believe growth and inflation are firm enough to keep global policymakers moving toward a reduction in monetary accommodation. While this process is likely to happen gradually, 2018 may experience a neutralization of extra liquidity growth that has provided fuel for asset prices in recent years.
- Growth in major central bank balance sheets is set to drop by $1.4 trillion over the next 12 months as the Fed winds down its balance sheet and the European Central Bank (ECB) pares back on quantitative easing (QE – see chart, right).
- The deceleration in liquidity growth may first affect the prices of riskier assets, especially smaller, more liquidity-driven categories of credit.
- As the primary driver of global liquidity over the past 2 years, the ECB's QE program has been particularly important to some markets, as European holdings of corporate bonds increased sharply during the QE upturn.
- In general, slower global liquidity growth may translate into higher market volatility.
Will the "Goldilocks" market backdrop persist?
There are many other potential scenarios for 2018, and perhaps the foremost question is whether the "Goldilocks" conditions can continue and whether asset prices can continue to climb in a broad-based manner with low volatility. Here are some developments that could support that scenario:
- If inflation slows further and monetary policymakers tighten less than the market expects
- If economic policies (deregulation, tax legislation) spur business confidence and productivity-enhancing capital investments
While we don't consider it the most likely sustained scenario over the next 12–18 months, an extension of disinflationary mid-cycle conditions could spur a market "melt-up" scenario for risk assets.
Asset allocation outlook
Financial markets will enter 2018 with positive momentum and a solid global corporate and economic environment. Nevertheless, our business cycle framework suggests the more mature an expansion becomes, the greater the downside risks for asset returns on an intermediate-term basis. For instance, using historical patterns as a guide, the performance of a diversified portfolio beginning in the mid-cycle phase typically experiences steadier, positive returns over the subsequent 3- and 5-year periods. If the performance of the same portfolio begins in the late-cycle phase, there is a broader range of return possibilities and a generally less attractive risk-reward profile (see chart, below)
In addition to a maturing US business cycle and the shift toward global monetary tightening, there are a number of other factors that make us less confident about making large asset allocation tilts at this point compared to earlier stages of the cycle. Elevated valuations across most asset categories imply more positive expectations have been priced into the markets. Geopolitical risks, particularly North Korea's pursuit of long-range nuclear capabilities, are in a rising trend. In addition, other political risks, including the potential for protectionist policies, should not be discounted.
As a result, our cyclical asset allocation view is to prioritize diversification in order to guard against the increasing uncertainty of outcomes and potential pickup in volatility that we expect during the course of 2018. Within the context of smaller cyclical tilts, we remain favorably disposed toward international equities and inflation-resistant assets.