11.01.2018 | 12:40

BNP Paribas AM: "If it’s so perfect, why are we so nervous?"

Solid global growth points to positive outlook for risk-weighted assets. However, volatility - and interest rates - should rise over the course of the year. Experts at BNP Paribad have identified two main risks: a possible recovery in inflation and a change in the dynamics of government bond delivery.

At the start of a new year, I often find it useful to look back on our commentary from 12 months earlier. Reviewing that commentary, what strikes me is how little the political risks that we and others had highlighted mattered for markets in the final analysis. President Trump certainly dominated the headlines last year, but some of the risk scenarios that had investors wringing their hands, for example a possible trade war between the United States and its major trading partners, never materialized. Across the Atlantic, the populist wave that set the United Kingdom on a course for Brexit dissipated against the breakwater of the Eurozone, leaving Euro-skeptic parties largely out in the cold. Instead, what mattered most for markets in 2017 was the sustained pickup in global growth, supported by still-easy monetary policy from major central banks who signaled that future reductions in accommodation would be measured. Indeed, the number of major economies experiencing positive quarterly growth in 2017 has not been seen since the early days of this expansion. Throw US fiscal stimulus into the mix, add a pinch of tax reform, and it is not at all hard to see the ingredients of a powerful energy shake for risk assets

Chart 1: Synchronized Global Growth

(Source: Q/Q real GDP growth through Q3 2017 for 25 economies representing over 80 percent of 2016 global GDP.)

For the time being, the relation trade is back, with most economists calling for a further pickup in global growth and stable-to-rising inflation in major economies. It is easy to focus on the United States given fiscal stimulus that would make the staunchest supply-sider blush and comes on the heels of a pick-up in growth. But we should not forget that perhaps the biggest growth surprise has been the Eurozone, where if anything, survey data suggest that the recovery is gathering momentum. In addition, the recovery there extends beyond core economies, and has not simply been driven by stronger global growth; domestic demand accounts almost entirely for the recent pace of Eurozone GDP growth.

Chart 2: Level of GDP for Select Eurozone Countries

(Source: Haver, as of December 2017)

Another solid year for global growth would certainly be welcome, given the slow progress in working through negative output gaps in many economies since the financial crisis. In addition, strong growth will support further job gains and brings the potential for sorely-needed wage improvement in developed economies. But in the United States, there are medium-term reasons for concern with growth in the 2.5 to 3 percent range this year. Specifically, the tax measures passed through Congress are more stimulus than reform, at a time when the economy is already operating at full employment.

Unless the tax measures meaningfully boost productivity growth, they may ultimately serve to bring about a tighter path for monetary policy, raising recession odds two to three years down the road. Thus far, Federal Reserve officials have already voiced skepticism that the tax cuts will meaningfully impact trend growth over the medium-term. More likely, corporate tax reform will be a further boon to equity market investors as the only trickle-down will come in the form of share buy-backs, dividends and other stock-friendly initiatives. Finally, the impact of tax cuts on the deficit could leave the government constrained in deploying counter- cyclical measures in the next recession, leaving the heavy lifting once again to the Federal Reserve.

These are all concerns for another day, and markets are unlikely to focus on them any time soon. In the meantime, we maintain our cautiously optimistic outlook for risk assets over the next several months, as two of the main risks that we wrote about last quarter - inflation and changing supply dynamics in sovereign bond markets – do not appear to be on the immediate horizon. Among developed economies, the most obvious place to expect an uptick in inflation is the United States. Not only did 2017 set a low bar to clear, with core CPI slowing to a 1.7 percent y.o.y. rate, but the output gap is now closed and the labor market is operating with little remaining slack. However, base effects suggest that it will be at least April before y.o.y. inflation will show signs of firming. In addition, outside of shelter there is little evidence of firming in core inflation components. Price inflation in a number of important sectors such as health care are driven by sector-specific factors that have little to do with the business cycle – and these factors point in the direction of muted price pressures.

Chart 3: Select CPI Inflation Components

(Source: Bureau of Labor Statistics, as of December 2017.)

We are also mindful of upcoming changes in the net supply of sovereign bonds available to the private sector. There are two considerations here – the need for the US government to increase issuance to fund tax cuts, and reductions in the aggregate sovereign debt holdings of the Federal Reserve, Bank of Japan (BoJ) and European Central Bank (ECB). In theory, these two sources of increased government bond supply have the potential to send rates significantly higher over the course of the year. In practice, however, this risk may not crystallize in the very near term. On the US fiscal side, the Joint Committee on Taxation, the official Congressional scorer of the Tax Cuts and Jobs Act (TCJA), estimates a $104 billion addition to the FY 2018 budget deficit as a result of the tax law changes, after accounting for positive macroeconomic effects. Treasury may begin to see an impact on cash inflows as soon as mid-February, and could announce higher coupon issue sizes as early as the next refunding. But Treasury may also rely heavily on higher bill issuance until they have a better sense of the impact of tax cuts on their cash positions. In addition, Treasury has announced that it anticipates keeping the weighted average maturity of the debt stable, implying limited risks of large issuance increases further out the curve. The experience with the Bush tax cuts also suggests that, faced with higher financing needs, Treasury may ultimately respond by reducing the maturity of the debt in order to keep down interest costs.

We are as much focused on central bank balance sheet policy as we are on forthcoming Treasury supply increases. Not only will the Federal Reserve accelerate the pace of balance sheet runoff over the course of this year, but much more important changes in balance sheet policy are in the offing from the ECB, and possibly the BoJ. In the introductory statement from President Draghi’s December press conference, the Governing Council signaled greater confidence in reaching its inflation objective, and investors are debating whether asset purchases will continue beyond September. The recent market response – notably higher rates and a steeper curve – to comments from Executive Board member Benoit Coeure that there is a “reasonable chance” that last October's asset purchase extension could be the final one suggests just how sensitive markets would be to a sudden stop to ECB sovereign purchases. Most immediately, we expect a shift.

As for the BoJ, we see the possibility of some modest changes to balance sheet policy in light of solid growth momentum and receding risks of deflation. In addition, if global yields rise it will be easier for the BoJ to justify raising the yield cap on 10-year securities, or rolling the cap down the curve. Signs of mounting wage pressure resulting from the Spring wage round could also presage a modest removal of policy accommodation.

Even if changes to the ECB and BoJ balance sheet policy do not occur until late in the year (or possibly 2019, in the case of the BoJ), we are cognizant that asset purchases by both central banks have been instrumental in suppressing term premia globally. As a result, signaling of future policy adjustments could lead to a repricing of global risk-free curves well in advance of the policy change, especially if combined with signs of inflation moving higher in the US and news from the Treasury on financing larger deficits. In this scenario, the outlook for risk assets and carry trades could quickly deteriorate.

Investment implications

The macro backdrop suggests that a supportive environment for risk-taking remains in place, at least for a while longer. Still, we are cognizant that volatility is likely to rise over the course of the year. We are focusing much of our analytical resources on the likelihood of higher rates in the G7 space. At this juncture, however, we are still not convinced that more than a minor structural short is in order. We are still comfortable with bear flatteners in Treasuries as a longer-term trade, but we acknowledge how far this trade has progressed already. As we wrote last quarter, the key wild card will be inflation and we are continuing to see a few signs that inflation pressures are beginning to return. While positioning for modest increases to inflation expectations, we are equally conscious of how a reduction in inflation pessimism could cascade throughout the system to affect policy, yields and the complacency that envelops all asset classes. In short, and no different than the last quarter, we remain simultaneously risk on and extremely nervous doing it.

Dominik DeAlto, Chief Investment Officer - Fixed Income