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Five key themes that Aviva Investors think will drive financial markets

21 October 2019

The asset manager has highlighted the issues that are catching the attention of its team of investment strategists.

By Gary Jackson,

Editor, FE Trustnet

Episodic volatility spikes, an escalation of the US-China trade war and a continued slowing in the global economy are some of the major themes on the radar of Aviva Investors.

In its latest House View report, which explains the thinking of the asset manager’s investment team, strategists at Aviva Investors highlighted five key investment themes that they expect to drive financial markets.

Stewart Robertson, senior economist (UK and Europe) at Aviva Investors, walks us through these five themes below.

 

1. Weak global growth

Global economic growth has continued to slow in 2019 and, as the outlook remains “fragile and uncertain”, is likely to cast a shadow over investor sentiment. The International Monetary Fund recently cut its GDP forecast for 2019 to 3 per cent, which would be its lowest level since the recession of 2008–09.

“The best that can be said is that [the slowdown] has not intensified dramatically on a global basis (although it has in a few key regions) in recent quarters,” Robertson said.

“But with risks skewed to the downside and recession threat rising in some countries, it is entirely understandable that questions are being asked about the sustainability of the present economic expansion.”

Global growth continues to slow

 

Source: Aviva Investors, Macrobond, as at 27 Sep 2019

Looking at the longer historical context, the economist noted that just nine of the past 40 years have seen weaker global growth, so 2019 is looking like it will a year of bottom-quartile macroeconomic performance. What’s more, 2020 seems likely to be even weaker, with aggregate growth expected to fall to an annualised rate of around 2.75 per cent.

Robertson added that main drivers of this slowdown are well-known and centred around the trade tensions between the US and China, which have had a significant impact on global manufacturing and world trade.

“The worry is that the longer this goes on, the more likely it is that weakness will be passed on to domestic demand, which until now, has been extremely resilient,” he said. “The channels by which any such transmission takes place are likely to be first, business sentiment, second, investment and finally, employment.”

Business sentiment indicators have already weakened in most nations (“quite alarmingly in some cases”, according to Aviva Investors) while investment has slowed significantly. However, labour markets have so far held up and supported household expenditure.

Looking ahead, Robertson said the outlook “remains one of low growth rather than no growth” – although this could change if labour markets weaken or consumer confidence plummets.

 

2. Dovish bias to monetary policy

The decade after the global financial crisis was marked by ultra-low interest rates and unprecedented quantitative easing programmes, with the tone of recent years being a move towards a gradual normalisation of monetary policy.

But central banks’ response to today’s weaker economic growth rates, lacklustre inflation and the trade war has taken the form of an increasingly accommodative monetary policy stance.

“There is a lively debate about where the new ‘neutral’ is in the post-crisis world and indeed whether it is even positive in several countries. But the key point is that central banks are back in stimulus mode almost everywhere and the main issue now is simply how far they will go,” Robertson said.

“Financial markets are expecting a lot and while we agree that a dovish bias is appropriate in today’s conditions, should downside risks ease, they may not need to (or want to) deliver quite as much as is currently priced in.”

Aviva Investors’ house view is that central banks’ dovish bias is likely to stay in place for the coming year or so – especially as there have been no signs of a general overheating of the economy.

“In the past, such episodes have been characterised by rising inflation pressures to which central banks have been obliged to respond, often killing off the economic upswing,” the economist said.

“The absence of such pressures today provides the monetary authorities with almost total freedom to react to growth concerns and downside risks and that is what they are doing. Until growth revives and/or risks dissipate (and assuming inflation stays well behaved), they will be comfortable in adopting such an approach.”

 

3. Trade dispute continues

In keeping with Aviva Investors’ close watch on weakening global growth, the firm also expects the US-China trade war to frame the investment landscape for the foreseeable future, predicting periods of calm followed by US president Donald Trump ratcheting up his ‘America First’ agenda and China responding.

“Before condemning the Trump administration totally, it needs to be acknowledged that some of their grievances with China are legitimate, especially with regard to intellectual property theft and access to China’s markets,” Robertson said.

“But weaponising tariffs and the like sets a dangerous and worrying precedent. Moreover, the risk of such measures spreading to other nations and eventually resulting in an all-out, tit-for-tat and damaging trade war is one that is already impacting business sentiment and financial markets, even if it were never to materialise fully.”

Adverse impact from US-China tariffs 1 Hit to GDP (difference from base)

 

Source: Aviva Investors, Macrobond, as at 27 Sep 2019

Aviva Investors’ central view is one where there is continued tension and intermittent escalation of the trade war rather than resolution, meaning that markets will remain susceptible to ‘headline’ or ‘tweet’ risk.

It also assumes that the announced additional tariffs are implemented in full, which will not only have a direct impact on trade flows, but add to uncertainty about trade policy, hinder cross-border investment and disrupt supply chains.

“In the event that trade tensions ease, global growth could be stronger, but the most likely scenario is one where uncertainty persists and that this in itself will be sufficient to hurt growth,” the economist said.

 

4. Fiscal activism returns

The fourth theme being watched by the team at Aviva Investors is the pressure being put on governments to use fiscal spending to support growth where possible.

“It has even been suggested that the arbiters of the fiscal purse should pick up the policy baton from their monetary equivalents. In the era of independent central banks, policy boundaries were generally respected,” Robertson continued.

“Today the edges are more blurred, the latest example being the ECB stating explicitly that the time was right for fiscal authorities to share the burden in the provision of policy stimulus.

“Both the IMF and the OECD have been unusually vocal recently in their support of such initiatives, with the latter stating that ‘exceptionally low interest rates provide an opportunity to invest in infrastructure that supports near-term demand and offers (long-term growth) benefits for the future’.”

The asset management sees a return to the large-scale Keynesian fiscal interventionism of the 1960s and 1970s as “highly unlikely” but added that fiscal policy seems set to add a small boost to growth in coming years – which is a big difference from drag created by years of austerity.

But the fact that public finances have now been restored in most countries means that there would be more fiscal firepower to hand if the economic slowdown were to become more severe.

That said, the economist added that caution is warranted when assessing the room for fiscal expansion as vulnerabilities remain in many countries despite the improvements in recent years.

In the US, for example, Trump’s “fiscal largesse” in 2017/18 means the budget deficit is approaching 5 per cent of GDP and there is now very limited capacity for any repeat, even though the economy is slowing. In Germany, there is little public appetite to boost fiscal stimulus even though the country has “ample scope” while the rest of Europe has too much debt to consider it.

Robertson summed up: “Our central view is that fiscal policy can deliver a valuable lift to aggregate demand in many countries in future years but that it will not be a game-changer.”

 

5. Volatility here to stay

The final theme in the group’s house view starts with the observation that recent years have been characterised by extended periods of market calm only for volatility to spike significantly and led to relatively large price movements.

“This pattern has been observed increasingly in different markets including equities, commodities and government bonds despite efforts by central bankers to extend the economic cycle,” the economist said.

“We expect to see this pattern continue. History shows that extremes in cross-asset volatility occur at the ends of economic expansions when growth begins to slow meaningfully.”

 S&P 500 60-day realised volatility

 

Source: Aviva Investors, Macrobond, as at 27 Sep 2019

Given that the economy seems to be well past the mid-point of its expansion phase, Aviva Investors expects volatility to continue to be “an episodic feature” of equity markets.

Added to this is the considerable change to market structure that has emerging since the global financial crisis, whereby non-discretionary flows and share buyback programmes have become the marginal buying forces.

These factors have helped to support upside market moves while limiting volatility and have been further reinforced by increasingly large waves of short-dated option selling as risk-taking sentiment builds.

“Such forces help to provide significant downward pressure on volatility, which becomes self-reinforcing as the low-volatility period progresses,” Robertson explained.

At the same time, the market impact of crowded position de-risking, the closing out of short volatility positions and a dearth in trading liquidity have contributed to volatility spikes that look large in comparison to the calm came before them.

“We feel this pattern of long periods of low volatility interspersed with significant spikes will continue, provided that global growth does not fall significantly further below potential,” Robertson concluded.

“However, since risks to the global economy seem skewed predominantly to the downside at present, there are already a number of catalysts for asset price volatility to persist. Were growth to deteriorate further, cross asset volatility will likely remain at more consistently elevated level across the board.”

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