H1 2018: Macro House View

Despite political kerfuffles in the developed world and tightening global monetary policy, The state of the world economy can be summarised in one chart, below.

Chart 1: 2017 was the first year where all of world's largest economies are expected to grow in sync for the first time since global financial crisis

Green indicates positive quarter-over-quarter growth

Stock markets, whose returns are correlated with economic growth, also saw a fantastic year, with the S&P 500 & MSCI Developed World indices both rising nearly 20%, while emerging markets (in USD terms) returned a remarkable 34.3% over the 2017 calendar year. For now, the growth has ignored any murmurs of irrational exuberance and continued to outperform in the first month of 2018. At the time of this writing, the S&P 500 has returned 5.5% year-to-date, the Euro Stoxx 50 returned 6.0%, the Nikkei 6.4%, and the MSCI Emerging Markets Index by 6.5%. To see how unsustainable this is, consider that a 5.5% return over 20 days equates to 166% return over one year. Which one is more likely - that the S&P 500 exceeds its highest annual historical return (45% in the year 1945) by over 3x, or that stock markets may not grow as fast as expected for the rest of the year?

Chart 1: S&P 500 is unlikely to grow at the rate we've seen far this year

S&P historical annual return in blue, annualised growth for YTD 2018 in red

Source: Bloomberg, author's calculations

Warren Buffett once said: "We simply attempt to be fearful when others are greedy and greedy only when others are fearful." 2017 was a year where it was difficult to lose, where those who made 20% from holding a stock market ETF - a fantastic return compared to almost any year in history - complained about others who made 200%, 500%, or 1000% from Bitcoin. In this environment, it is easy to let greed take over; in this environment, we choose to tread cautiously.

What is there to be fear? Several things come to mind.

#1 Fear: Central bank tightening

How much of our current economy is fuelled by normal growth and how much is fuelled by the massive balance sheets of central banks? Just because we don't see the physical money doesn't mean it isn't floating in cyberspace, flooded in the wires between the central banks and the financial institutions that then disseminate it into our world. In our view, this is a major headwind for both economic and capital markets growth in the coming year, as Fed, ECB, and BoJ looks to discontinue, decrease, or ease on their respective quantitative easing programs. Central bank tightening will have all types of follow-on effects for the economy, and informs our views on fixed-income (underweight), equities (underweight), and commodities (overweight) & FX (overweight EUR).

#2 Fear: Geopolitics

Wall street currently has its ears closed to the noises in Washington DC. Perhaps they are correct to do that - economic fundamentals are strong, as we've already stated before. In particular for the US, unemployment rate - currently at 4.1% - continues to break cyclical lows and is now lower than the period right before the global financial crisis. Wage growth has trended up towards 4% year-over-year in the latest data point (November 2017), and small business optimism is also hovering near 15-year highs. If anything, we concede that perhaps it is the politicians that are overly-dramatic this time.

However, policy changes, like recently approved tax cut (our analyst Bryan Si wrote an article on the website in more detail about this), renegotiation of NAFTA, and Brexit negotiations in Europe all have long-term implications that are not quite clear at the moment. In this respect, markets seems to have taken a "no news is good news" approach, which we caution could lead to an eventual rude awakening. In particular, decreased fiscal responsibility from the US and increased isolationist sentiment both have negative long-term implications for global trade and growth. Buyer beware.

Finally, we believe that recovering commodities prices give the Middle East more fiscal leeway, and may hinder its ambitious 2030 plans to become less dependent on oil (see analyst Sainka Shah's article on our website). However, if the OPEC countries - particularly Saudi Arabia - continue to shift their concentration away from energy production and into other industries, commodity prices is well on its way to continue its recent recovery. We believe that this offers a bright spot in our largely cautious view. Backed by a fast-improving world economy, demand for energy and base metals are likely to increase, while the supply side may choose to tread cautiously, not wanting to risk flooding the market and repeating the 2014-15 crash.