12th December 2017
It’s the most wonderful time of the year…..that is, when the Sell Side release their forecasts for 2018. A cursory glance across Street estimates has 2018 US GDP comfortably above 2.5%. When coupled with tame inflation and low rates, it is no wonder the so called investor wall of worry is crumbling in front of our eyes as we head into 2018. A “remarkably benign” macroeconomic environment is how one Wall St bank put it. “Positioning for euphoria”, read another recent headline on Bloomberg TV. Just in case we were in any doubt of the current market psyche. Thankfully we can now trade bitcoin futures on a recognised exchange!
There are a number of caveats to the above – there always are – however en masse they appear to be banished from the conversation until 2019 at the earliest. Much of the euphoria of course is predicated on the goldilocks balance of high growth and low inflation with no one contemplating a shift in this dynamic. With this in mind, beware the unexpected jump in inflation. Behind the scenes the reality is that a substantial amount of Central Bank activity will be taking place in 2018. Within developed markets, signs of economic overheating are already starting to appear (witness German inflation) while the US is adding a $1trln fiscal stimulus package – largely for the benefit of the top 1% – at this late stage in the cycle. Mindless in our view, but whatever the motivation there may well be a serious need for monetary restraint in 2018. Indeed we just might get it.
Looking at the bottom up perspective, as we have been highlighting for the past couple of months, cracks continue to emerge in certain areas of the credit markets. Cyclical sectors such as semiconductors and base metals have trended down since late November while the BofAML High Yield Index experienced its worst monthly return since November 2016. In Europe single B rated issuers Altice (telecoms) and Astaldi (construction) led a reversal in Euro High Yield – the 4 weeks to December 6th has seen €2.2 bln of high yield outflows according to JP Morgan. Last month we touched on the woes of Steinhoff’s bond investors, who having bought an 8 year IG rated bond at 1.25% suffered a 20 point loss on allegations of fraud. The situation worsened as the CEO resigned amidst an investigation into accounting irregularities – causing the bonds to trade down into the 40s. Interestingly, the ECB are in fact a holder of this bond – the second instance of a central bank said to be owning a distressed credit after it transpired the BoJ were a holder of embattled Japanese company Kobe Steel.
A last word on the technical outlook. The short volatility trade is looking precariously stretched and even the slightest jump in volatility numbers could start a chain reaction (not unlike what happened to the Death Star) that could turn passive investing and risk parity strategies on their heads. Are we witnessing the classic end of cycle euphoria? Who can honestly say. The question is how long to stay invested. Whilst there is a danger in getting out too early, at least you can avoid getting burned.