Markets are trying to get their heads around whether new developments, such as inflation, protectionism and interest rate rises, are short-term reversals or something more structural, writes Anthony Rayner
A number of multi-decade, multi-dimensional trends are currently being challenged. From an economic perspective, we have moved from a disinflationary environment, which has dominated since the 1980s, to an inflationary one.
Geopolitically, globalisation and free trade, which have been the prevailing orthodoxy for decades, are being challenged by a shift towards protectionism. At the same time, monetary policy has done a handbrake turn, away from quantitative easing, with interest rates rising from multi-decade lows.
Of course, these dynamics are not operating in isolation of each other. The Chinese economy joining the world economy back in 2001 was a major driver in pushing global consumer and wage inflation lower, while the recent inflation pick-up is one of the reasons interest rates are on the rise.
Unsurprisingly, the combined effect of these forces is leading to a pick-up in equity market volatility, reflecting a higher degree of uncertainty. This feels particularly volatile, coming as it does after a period of fairly black and white markets, characterised by an extended period of ‘lower for longer', when interest rates and bond yields moved to multi-decade lows, before a rebound in growth and an inflation pick-up signalled a ‘reflationary' period.
The following graph sketches out this economic context and its impact on equity markets. The US ISM manufacturing survey has been a pretty good proxy for US economic growth over time, showing the latter part of the lower for longer period (anything below 50 is considered consistent with economic contraction), before giving way to a building economic growth momentum from the beginning of 2016.
Source: Bloomberg, 01/10/2014 to 28/03/18
As you can see, we have also plotted the FTSE World cyclicals index relative to FTSE World defensives, which shows clearly how cyclicals underperformed defensives during the lower for longer period, while cyclicals have outperformed in the reflationary period.
During these two distinct periods, once the economic scene was set, equity markets and most other assets behaved in a fairly understandable way. That said, at the turning point in the first half of 2016, there was a lot of ambiguity in the data, which translated into a directionless period for equity sectors.
The possibility we are seeing another turning point now, after a very strong run from cyclical sectors, combined with what appears to be a shift in some of the longer-term dynamics, is leading to a period of head-scratching for markets.
It is fair to say there is decent economic momentum globally, with a pick-up in inflation that is encouraging at these levels, rather than discouraging, while the path of US interest rates have been fairly clearly signposted. As ever, there are risks to the more probable range of scenarios but an economic base case can be fairly easily constructed which, on many levels, feels like a sensible exit from an extremely unusual period in economic and financial market history.
Questions remain as to whether markets will respond to this in a disorderly manner or not and it is unclear at this stage which part of the equity market will lead from here - if, indeed, the market will be led higher.
Turning to protectionism, at this stage it is probably fair to say we have reached ‘peak globalisation' with global trade as a percentage of GDP falling in several consecutive years now. That does not answer the question of whether we are heading into a trade war proper - and by that we mean action severe enough to lead to materially slowing economic growth and further momentum to inflation, or stagflation.
Gauging the answer as to whether protectionism will increase materially is difficult as it involves understanding political actors, though in certain parts of the world this has got easier. The Chinese president is now ‘president for life', while the Russian president looks to have at least another six years, and in many ways both have set their stall out pretty clearly.
Donald Trump, from where the recent protectionist measures started, has been less easy to get a handle on - partly as he is so unconventional but also because his belief system is less clear-cut.
What we can say is he is surrounding himself with an increasing number of economic nationalists and short-term political opportunism might be more tempting than economic rationalism.
Markets are trying to get their heads around whether a number of new developments, including inflation, protectionism and interest rate rises, are short-term reversals or something more structural.
The market's job is to extrapolate - ours is to construct a portfolio for the data we can see in the here and now. As a result, we retain a cyclical bias in equities and a bias for short-duration, good-quality corporate bonds. As ever, liquidity is key for us, so we can move quickly if the data changes.
Anthony Rayner is co-manager of Miton's multi-asset fund range
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