While risk assets have rallied strongly since the end of last year, investors may need to prepare for greater volatility later in 2019 as three key macroeconomic factors start to diverge, according to PIMCO’s Joachim Fels.
After a 2017 unusually devoid of volatility, last year saw a return to more familiar levels.
However, markets have once again seen low volatility in 2019 as many of the major challenges of 2018 have seemingly been resolved.
Performance of index YTD
Source: FE Analytics
PIMCO global economic adviser Fels said markets can be interpreted by looking at three main macroeconomic factors: the business cycle, liquidity cycle and political cycle.
“These days, each of these cycles is global,” he said. “The three interact and influence each other, but each has its own key driver.”
For example, the business cycle is largely driven by the Chinese economy, said Fels, which can be seen in the ups and downs of global trade.
“This is different from the old days, when the US consumer was the engine for the world economy,” he explained.
Meanwhile, the liquidity cycle continues to be driven by the US Federal Reserve, whose interest rate decisions drive global trends. It is also responsible for dollar liquidity and, as such, has a big impact on global risk appetite.
Finally, the political cycle has also become more global in recent years with the ascent of populist leaders and parties.
“When it comes to the impact on markets, populism has a friendly and an ugly face,” he said. “The friendly face is fiscal easing in the form of tax cuts and – moderate – spending increases that support supply and demand – financial markets usually welcome this.
“The ugly face is nationalism and protectionism, which markets dislike.”
Fels said the relationship between the three cycles can determine the short- and medium-term direction of markets and is particularly strong when all three move in the same direction.
Such an example could be seen in 2018, he said, where all three cycles turned down, making it a bad year for most asset classes.
The PIMCO strategist said the global business cycle peaked early last year because of China’s deleveraging campaign and growth slowed during the course of the year.
Meanwhile, the global liquidity cycle deteriorated after the Federal Reserve made four rate hikes and started to shrink its balance sheet. This saw dollar liquidity tighten, which had a major impact on emerging markets.
“In addition, the political cycle deteriorated as populism showed its ugly face with the US starting a trade war with China and a newly elected populist government in Italy picking a fight with its European partners,” he added.
Performance of indices in 2018
Source: FE Analytics
As the above chart shows, the MSCI World was down by 7.38 per cent, while the MSCI Emerging Markets index fell by 10.08 per cent, in US dollar terms.
However, it wasn’t just equity markets that had a bad year. In the fixed income universe, the Bloomberg Barclays Global Aggregate - Corporates index was down by 3.57 per cent while the government debt index – Bloomberg Barclays Global Treasury – dropped 0.38 per cent.
So far this year, however, risk assets have performed strongly with the developed markets-focused MSCI World up by 15.56 per cent while the MSCI Emerging Markets index rising 12.23 per cent.
However, there are some important changes to Fels’s three cycles that investors need to pay attention to this year.
Since the start of 2019, he said, the three cycles have begun to diverge and that could lead to higher volatility.
While the global liquidity cycle deteriorated last year, there has been an improvement somewhat in 2019, he said following the Fed’s ‘triple pivot’ on rates, the balance sheet and inflation-targeting strategy.
“This was likely the main driver for the rebound in risk assets since the start of the year,” explained Fels. “However, with markets now expecting a Fed rate cut sometime over the next 12 months, the central bank’s more dovish stance seems to be fully priced.”
Secondly, while there are few ‘clear signs’ of a rebound in the global business cycle it has likely stopped deteriorating with improving economic indicators.
“With China’s credit and fiscal stimulus likely to find more traction in the coming months and global financial conditions having eased substantially since the start of 2019, a moderate recovery in global growth in the second half of the year appears to be in the cards,” he said
Source: IMF
Finally, Fels said that the political situation could further deteriorate despite some positive developments recently, as the biggest challenge of last year – the US-China trade dispute – seems likely resolved, the PIMCO adviser. Yet this has already largely been priced-in and could now see president Donald Trump turn his focus elsewhere.
“Once a deal with China is done, president Trump looks set to threaten Europe with higher tariffs on imported autos in order to bring the EU to the negotiating table on agriculture,” he explained.
“Also, political risks in Europe are likely to flare up again after the EU parliamentary elections in late May, which could result in significant gains for populist parties – though the longer-term ramifications are less clear – and pave the way for new elections in Italy later this year.”
Fels added: “Taken together… global risk assets will most likely lack a clear direction this year and could become more volatile again.”
As such, he said the firm remains concerned about the potential for “rude awakenings” and market disruption as the result of recession risks, shifts in the balance between monetary and fiscal policy, trade tensions and political populism.
Fels said it makes sense to stick fairly close to home in terms of top-down macroeconomic risk factors and to seek income without relying too much on corporate credit. Additionally, it is remaining flexible and liquid to take advantage of periods of higher volatility and market dislocation later in the year.