14 Jun 2018
Italian politics; Sino-US relations; North Korea; US withdrawal from the Iran nuclear deal; import tariffs on cars, steel, and aluminum –topics like these have dominated financial headlines in recent weeks. For investors across the globe, it has become increasingly difficult to navigate the daily flow of geopolitical news, all while markets are moving along with the business cycle.
Granted, in the short run, market movements tend to be influenced by what's on the news and by swings in investor sentiment. But over periods of several months to several years, they tend to be driven by fundamental factors such as economic growth, inflation, and corporate earnings. This relationship is not always easy to spot, partly because asset prices incorporate new information very quickly – at times long before the same information becomes digestible to the general public.
For example, recessions are spotted in economic data a few months after the fact, yet they tend to be preceded by long-lasting downturns in risk assets such as equities and high yield credit – i.e. bear markets –around six months ahead of time.
Investors with a time horizon of at least six to 12 months can generally afford to ignore short-term noise from the media, but can typically not afford to go through a bear market without adjusting their investment stance. Therefore, it pays to screen the global economy for signs of an impending downturn.
In our view, markets are in mid-to-late-cycle territory, meaning the global business cycle is already quite advanced and the probability of a global bear market is no longer negligible. It should be clear, however, that not every risk highlighted by the media has an equal probability of triggering a bear market in the next six to 12 months. In the following section, we provide our view on what could pose a substantial threat to markets, and what are unlikely to disrupt markets beyond the short term.
Plausible risks to the business cycle
- Fed policy: Historically, recessions and bear markets are often preceded by interest-rate hiking cycles in the US. If US inflation rises too quickly, the Federal Reserve may be forced to start raising interest rates at an accelerated pace, potentially bringing the expansionary stage of the US business cycle to an end around 2H19. The risk of a Fed-induced bear market is the focus topic of this report, covered in the next section.
- Rising protectionism: With the US announcing tariffs on steel and aluminum imports from Europe, Canada, and Mexico; with NAFTA negotiations stalling; and with Sino-US trade disputes still unresolved, rising protectionism remains a palpable risk. Should trade restrictions escalate significantly, we would expect global GDP growth to slow by 0.5–1 percentage points relative to our base case forecast. For now, we believe the risk of a full-blown trade war is moderate, but will watch out for retaliatory measures that could challenge this view.
Remote risks to the business cycle
- The Middle East: Geopolitical escalation in the Middle East often causes shortages in oil supply, leading to sustained upward shocks in oil prices. In the 1970s and 80s, several oil price shocks caused by Middle East escalations impaired global economic growth and disrupted asset markets. Today, despite ongoing tensions in the region, this risk appears to be low, at least for now. First, shale gas producers in the US, which did not exist in the 70s, have an incentive to produce more as prices rise, which should then limit any oil price spikes. Second, many developed countries have become less dependent on oil as a factor of production. Combined with solid economic growth in most major regions, this means that the bigger economies should be able to digest higher oil prices without falling back into recession.
- North Korea: Recent media reports seem to center around whether Donald Trump and Kim Jong Un will meet this month. We believe this is of little consequence, since the diplomatic process around North Korea's denuclearization is likely to continue in any scenario. In addition, episodes of escalation on the Korean Peninsula have become less of a concern for global markets lately. We therefore believe the North Korea conflict is not likely to cause a sustained market downturn over our tactical horizon of six to 12 months.
- Italy: The recent political crisis in Italy briefly sparked fears of a repeat of the 2011–12 Eurozone crisis. But an exit from the monetary union has never been a part of the coalition partners' joint program. We will closely watch the political developments in Europe, but believe that the chances of a market stress similar to the one experienced in 2011–12 are low for the moment.
In an environment of uninterrupted political news and sizable market swings, it is important as ever for investors to focus on the relevant drivers of market performance. Over our tactical investment horizon of six to 12 months, these drivers include economic growth, inflation, and corporate earnings. We remain positive on these fundamental drivers, and advise staying invested.
That being said, higher volatility in financial markets is bound to translate into higher volatility for investment portfolios. One way to mitigate this is by diversifying across asset classes and regions. Still, the abundance of risks surrounding markets today may also call for a more targeted approach. Table 1 in the full report contains open CIO investment recommendations that we expect to perform well not only in our base case, but also in one or more of our forward-looking risk scenarios. (For details on all these investment ideas, please refer to the respective CIO publications and the UBS House View in particular.)
Download the full June edition of the Global risk radar.