Finding the real risks amid the noise

Market-moving news has been abundant of late: oil prices rose following the US withdrawal from the Iran nuclear deal; the US-North Korea summit was cancelled and then rearranged; Italian borrowing costs spiked and fell back on domestic political developments; and equity markets were unnerved by the protectionist stance of the US against major trading partners.

In recent years, ignoring the noise and staying invested has proven to be profitable. We are overweight global equities over our six-month investment horizon.

But, in our view, markets are in mid-to-late-cycle territory, meaning the global business cycle is quite advanced and the probability of a global bear market is no longer negligible.

In our latest Risk Radar, we try to separate the noise, which investors should look through, from the genuine risks to the business cycle, which investors need to monitor and mitigate.

Remote risks

We currently see the risk of an oil price shock, North Korean crisis, or Italy-triggered Eurozone crisis, as remote threats to the business cycle. Developed economies’ dependence on oil has fallen – OECD countries need 12% less oil to produce the same amount of GDP as in 2007, diplomatic efforts towards North Korean denuclearization are continuing, and an Italian exit from the euro is not on the new coalition government’s agenda.

Plausible risks

While these risks are relatively remote in nature, investors should monitor and mitigate risks of accelerated Fed hiking, and rising protectionism:

Fed hiking

Our base case is for three further Fed rate hikes this year. But US data showing that there are now fewer unemployed people than job vacancies means there is a risk that tight labor markets could drive higher inflation, forcing the Fed to hike rates faster. A higher cost of capital could halt US growth and would be negative for financial assets. We currently assign a 10–20% probability to this risk scenario.

Rising protectionism

US trade tariffs announced so far are not economically significant. But tit-for-tat retaliation could lead to a greater impact. Recent US action against Mexico and Canada is also important. US exports to China totalled about USD 32bn in 1Q 2018, versus USD 137bn of US exports to Canada and Mexico. Should protectionism escalate significantly, we would expect global GDP growth to slow by 0.5–1.0 percentage points relative to our base case. Weaker corporate earnings growth and higher risk premia would lead to lower equity prices.

Overall, we remain positive on equities over our tactical investment horizon of six to 12 months.

We forecast 4.1% global economic growth in each of 2018 and 2019, and strong corporate earnings growth. Investors should be able to afford to look through much of the current noise, but should consider action to prepare for the risks of accelerated Fed hiking, and rising protectionism.

Therefore, we recently introduced some countercyclical measures into our asset allocation. If the Fed hikes faster, e.g. five-year rates would likely move more than 30-year, as the latter are more influenced by long-term real growth and inflation expectations. For investors who can use options, long-dated put options on the S&P 500 or other indices offer protection against an earlier than expected end to the cycle. And in the event of a trade war, equity markets of export-oriented economies would be particularly exposed and we would expect emerging market currencies to depreciate against the USD.

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