By Michael McCarthy

Investors locally and globally are enjoying a Goldilocks moment. Share prices are buoyant. Markets are collectively expressing the view that the global economy is “not too hot, and not too cold”.

Not hot enough to spur sharp interest rate rises and stimulus withdrawal, not cold enough to spiral into recession and crises. One of the key investment challenges in 2017 is deciding how long conditions can remain “just right”.

Positive signs

The recent data from the USA is unambiguous. The economy is clearly improving. Growth in China defied the “hard landing” sceptics in 2016, coming in at 6.7%. Two of the three major engines of the global economy are in better shape. Europe remains a concern, as an anchor dragging on the global economy and as a source of systemic risk, but there are no signs of deterioration from current low expectations. 

This means the outlook for the global economy, and the bobbing cork that is the Australian economy, is modestly positive. However, significant risks remain.

The election of Donald Trump and the second-look perception that his populist policies will boost the US economy is dominating market thinking heading into the presidential inauguration on January 20. Additionally, monetary conditions are at their most accommodative, despite the interest rate increases from the US Federal Reserve. The Bank of Japan and the European Central Bank are still pumping away, supporting global asset prices, and the Fed appears nowhere near withdrawing its more than $3 trillion injection.

US S&P 500 Index

 

Given the underpinning of the largest monetary expansion in history, and an improving global growth outlook, it’s hardly surprising that share prices are hitting highs. In countries like Australia and Germany, the major indices are at better levels than at any time in 2016. In the UK and the US, share markets are at all-time highs. These highs come despite a litany of woes – slow European growth, unstable Italian banks, credit fears focussed on China, trade wars and currency impacts, among others.

Is it sustainable?

The answer is yes and no. The reason for the seeming contradiction is that the increasingly conflicting central bank flows as the Fed moves toward withdrawal, combined with fragile sentiment, will potentially mean further bouts of surging volatility. Although asset prices could rise, the path is likely jagged, with huge moves fuelled by investor sentiment swings. And periods between moves may be unusually quiet.

This volatility of volatility increases difficulty for those unprepared. Calm patches may lull, and subsequent moves terrify. Professional traders will search for “fat tail” events, those highly unusual market moves that inflate the extremes (tails) of the distribution curve.

Additionally, a sleeping dragon is stirring. Current concerns about inflation are centred on the lack of it. However, the US core inflation readings are at 2.1% pa, above the Fed’s 2.0% target. Unemployment is well down on post-GFC highs, underemployment is dropping and wages growth hit 2.9% p.a. at the latest read. The uptrend in both indices is clear.

If the newly elected President and Congress administer an economic sugar hit, bottlenecks could quickly appear. Acceleration in wages growth from current levels would quickly feed into an inflation burst. This could force the Fed’s hand on interest rates, and make current estimates of two 0.25% rate hikes in 2017 look dangerously conservative.

The worst case scenario is inflation breaking out and productivity growth remaining moribund. Stagflation is still quite low on most economists’ list of risks. A further uptick in inflation could change perspectives very quickly.

The rhetoric from Trump Tower is short on detail for any stimulus plans, or anything other than a southern border wall. Many commentators are cautious about the outlook for the Asia Pacific region given the potential for a Trump inspired trade war. Risk awareness is important, but few are focussing on the potential gains for the region. China’s pivot to Asia over the last decade could mean many are overestimating the strength of the US position in these negotiations. After all, the major economy with the strongest growth is China, not the US.

The defensive positioning of Asia Pacific markets, including Australia, contrast with US exuberance. These could see a sustained period of outperformance from local share markets. Lower currencies and the potential for further falls against a strengthening USD add to the argument for an overweight position in Asia Pacific equities.

Additionally, anything less than an out-an-out trade war should see the recent improvement in commodity prices continue. This should lend additional support to stock markets that have significant resource component. In a world of opportunities, sometimes the best investments are close to home.