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Back to Normal?

16 March 2018

Over the course of last week it felt very much as though things were returning to normal after the short sharp shock in equity markets in early February. Stock markets in the US have returned to their previous long term trading ranges, while markets elsewhere are slowly heading into the same direction. Even the diplomatic tit-for-tat action between the UK and Russia feel strangely familiar – although that stems from a time much longer ago.

It is notable that none of the pessimistic predictions that were released during the market correction are en-route to becoming reality. This is particularly true for the bond markets, where the rise in yields has plateaued and especially the yield for US 10 year government bonds has not advanced to 3% and beyond but even briefly fell back below 2.8%. Stabilising yield and inflation expectations bode well for a continuation of further corporate earnings growth around the world. This would help to underpin elevated stock market levels despite less favourable valuation metrics due to the slowly returning return competition of rising bond yields.

As long as stock markets do not get ahead of themselves again and bond markets remain as level headed as they have been, then investment returns are on track to return to positivity once more. Respected economists and central bankers frequently state that economic cycles do not ‘die of old age’ but because of either economic overheating, central bank policy errors or external shocks.

Unfortunately, all three are more on the radar this year than they were in 2017. A potential external shock could develop from the resurgence of trade barriers morphing into an outright global trade war. With the traditional leader of the free trade movement – the US – at its forefront this has the biggest upset potential at the moment – even if it currently carries a low probability. Donald Trump’s carry through from his periodic harsh rhetoric has been quite limited, whereas his medium term success rate regarding the stimulation of US business sentiment is increasingly undeniable.

It was remarkable to observe how the German press picked up on the fact that German cars suffer a maximum import duty of 1% in the US, whereas US car imports to the EU are charged at 10% – thereby not building public support for the EU’s notion of unfair US tariff threats. Could it be that Trump’s tariff shocker might actually lead to a general lowering of tariffs rather than a global trade war? This is currently quite an optimistic perspective and much will hinge on Trump’s approach and negotiations with China and whether his administration plays its cards well rather than aims to score populist points back home.

The other hurdle to watch are the looming interest rate hike by the US central bank (US Fed) and the UK’s Bank of England (BoE). Both are going to announce their March rate decisions in the coming week and so the fear and debate about the potential for central bank policy errors will resurface. Another 0.25% US rate rise is currently widely expected and therefore highly unlikely to cause turbulences. However, the Fed’s quarterly publication of their committee member’s combined forecast for their future decisions – called the dot plot – should be more interesting and inform us whether there may be reason to be concerned. The UK’s Bank of England is now less likely to raise rates this month, but we expect some decisive language that another rate rise is on the cards – we suggest this will take place in May, but then pause potentially until 2019.

Neither central bank’s potential rate hike falls into the policy error territory, but given the UK’s recent lacklustre economic progress, a UK rate rise would require more justification and would be aimed at stemming inflation pressures driven by currency weakness rather than an overheating economy. On the subject of the UK economy we received a comprehensive update this week through the chancellor’s spring (non-) budget statement (the actual budget moved to the autumn in  2017). While he was trying to paint a positive picture, the detail revealed that the public finances remain tight, despite recently improved tax revenues. No risk from economic overheating then and instead a chancellor who keeps the purse strings tight, just in case Brexit turns against the odds into a nasty shock and requires a fiscal bailout.

The heated diplomatic exchange with Russia over the reckless release of Soviet era nerve gas in the middle of Salisbury is also unlikely to morph into an economic threat scenario, given how little trade there is between the UK and Russia since the sanction of the Ukraine conflict.

This then leaves the general economic picture, which contained mixed news for market strategists. Lagging indicators tell us that the global economy was running towards the risk of overaccelerating at the end of last year, whereas leading indicators inform that is unlikely to be the case now.

All back to a far less fast moving picture then and much more reminiscent of the ‘old normal’ from 10 years ago. However, until we actually reach that old economic and monetary normal again, there are still a number of ‘new normal’ abnormalities which need to be unwound gradually or bear the risk of causing upset – just as the sudden jolt in stock market volatility back to normal levels did at the beginning of February.