As the current cycle extends beyond the recent historical experience, it is tempting to get caught up in the latest swing in sentiment, often driven by a partial data picture.
More from the Mid-Year 2019 GMO
Looking back over the past 12 months, we can see that the biggest lesson is to look through some of the temporary noise and consider where fundamentals might be taking us over the longer term.
For example, back in December, markets became overly concerned about the outlook for global growth, thanks to the impact of the US-China trade conflict and what many saw as the Fed’s overly hawkish tightening schedule. In fact, first quarter growth in the US and elsewhere was not as bad as feared and, while wage inflation and oil prices have risen, inflation overall remains manageable. Trade risk certainly remains a wild card, but if we continue to assume that the US and China will reach a deal late this year, even if their relationship remains strained for years to come, then the potential for modest economic growth over the next 6-12 months remains likely.
If a deal is reached, current monetary policy settings appear appropriate, and the Fed can remain on the side lines as it assesses the degree of slack in the economy and the level of unemployment, consistent with its dual mandate. The positive effects of China’s fiscal stimulus could gain momentum if the threat of further tariffs is lifted. Now the largest economy in the world on a purchasing power parity basis and the biggest contributor to global growth, what happens in China is becoming increasingly important to investors, especially as its onshore markets open up. Europe remains bound by political risks, but tends to follow global trends eventually.
From an equity market standpoint, volatility has begun to switch from complacency to panic and back again in a pattern consistent with late cycle dynamics. This and Fed dovishness has driven much of the rally in the first half, rather than earnings. However, with central banks capitulating on normalizing policy and growth drivers still in place, we would expect to see some improvement in earnings in the latter part of 2019, at least in the US. In the credit markets, US rates have come down and are close to fair value, while European rates are zero or negative. Chinese government bonds may offer better yields and are becoming easier to access; our research also shows they have attractive diversification properties for global bond investors. Credit spreads have tightened in the US and Europe, so it is worth staying light and opting for quality.
Finally, climate risk has moved up the agenda in the first half of 2019 and looks set to become an increasingly salient topic among investors. This is because of its potentially systemic effects on financial markets and the threat it poses to business models and long-term asset values across a range of asset classes and sectors. At State Street, we have developed new tools to identify and monitor climate risks at a security level and new strategies for investors to mitigate their climate exposures and take advantage of new opportunities. New macro measures of climate impact are also appearing that could influence the way we as a society measure growth and productivity and the direction of our future Global Market Outlooks.
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