First and foremost, the global business cycle has started to peak. The importance of this fact cannot be emphasized enough. This is not because a peak is necessarily negative for markets – they know recoveries cannot last forever. It is because the peaking cycle complicates the ability of investors to correctly assess the underlying trends in the economy and, even more importantly, to have conviction on the most probable future path for the business cycle. With data surprises and leading indicators sending more and more mixed signals, it becomes simply much harder to distinguish between the data noise surrounding a growth trend that is still healthy but more sideways, and the start of a more persistent cyclical downturn. We remain convinced that steady growth is much more likely to materialize over the next 12 months than a sharp downturn, but markets are always very sensitive to the “second derivative” in the evolution of economic news flow. Basically, the current data evidence adds uncertainty to the macro outlook. That creates upward pressure on risk premiums in markets (see chart) as investors demand more compensation for more uncertain future returns.
Global risk premiums
Source: Thomson Reuters Datastream, NN Investment Partners
Moreover, a more uncertain growth outlook means less protection against political or other types of shocks that hit the global economy. From the middle of 2016 until the beginning of this year, the global economy was on a steady and increasingly synchronized recovery trend. This made it easier to digest shocks such as the Brexit referendum or the Trump election. Investors knew that macro and earnings fundamentals had a robustness that made it very hard for political drama to derail the recovery. Now it has become a bit more difficult for investors to “trust” the business cycle to stay on track regardless of what happens in the political arena.
The second crucial point is that for the first time since the end of the Euro Crisis, the political noise has started to bite for real. In the previous two years, political noise came mainly in words, while policy action often was in fact positive for markets (like the US tax cuts). This year, however, the talk on trade translated into actual tariffs and a much more confrontational US stance toward a number of its important trading partners, most notably China and the Eurozone. This adds a layer of uncertainty to the outlook for the global cycle.
At the same time, however, it is hard to imagine scenarios where the current trade conflicts will translate into a positive force for global growth in 2019. So, there are more macroeconomic and political challenges, but certainly not less opportunity in markets.
One reason is that more uncertainty about the outlook and more volatility in markets create more room to actively exploit some of the price dynamics in the market.
A second reason is that taking risk in global capital markets is still nicely rewarded. As the chart shows, only in government bond markets have risk premiums declined over the first half of the year. This was especially the case in the US, where the flattening of the yield curve has resulted in below-average risk compensation for investors. In other parts of fixed income markets, however, spreads over government bond yields have widened substantially.
With respect to equity markets, timing can also remain challenging in the near term. The good news from second-quarter earnings reports has just been digested. Now, with earnings growth set to slow down over the next 12 months and the business cycle on a sideways rather than accelerating patch, equity markets will remain exposed to the influence of investor sentiment with regard to trade-war stories and further disappointing news about the technology sector. Still, the equity risk premium remains attractive (see chart).
As we approach the close of summer, the end of the year continues to look bright. Clouds of uncertainty will not disappear immediately, but seasoned investors know that opportunity is often just around the corner when opinions diverge and markets have been shaken. It’s not a time to be hasty, and some tremors could persist, but my summer thinking has sharpened my appetite for new opportunities in the remainder of the year.
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