Risk assets have staged a remarkable rebound from dark days of December, but how long can the rally last?
In taking a macro approach to the cyclical outlook for asset markets, I often use this simple framework: There are three main macro factors for markets – the business cycle, the liquidity cycle, and the political cycle. These days, each of these cycles is global. The three interact and influence each other, but each has its own key driver.
The global business cycle is largely driven by the Chinese economy, which dominates the ups and downs of global trade. This is different from the old days, when the U.S. consumer was the engine for the world economy.
Meanwhile, the global liquidity cycle continues to be driven by the U.S. Federal Reserve, which dominates global interest rate trends, dollar liquidity, and global risk appetite.
The third macro factor – the political cycle – has always been around, but it used to be largely domestic and mostly benign for developed financial markets. Yet, this has changed in recent years with the ascent of populism as a global force. When it comes to the impact on markets, populism has a friendly and an ugly face. 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.
When the three cycles move together
In my simple framework, the interplay of the business cycle, the liquidity cycle, and the political cycle largely determines the short- and medium-term direction of asset markets. The momentum is especially powerful when all three go in the same direction. This was last the case in 2018: The global business cycle peaked early last year in response to China’s deleveraging campaign and growth slowed markedly during the year. Likewise, the global liquidity cycle deteriorated as the Fed hiked rates four times and shrank its balance sheet, thus withdrawing dollar liquidity and hitting emerging markets particularly hard in the process. In addition, the political cycle deteriorated as populism showed its ugly face with the U.S. starting a trade war with China and a newly elected populist government in Italy picking a fight with its European partners. Hence, 2018 was a bad year for most asset classes, as all three cycles turned down.
When the three cycles differ
Since the start of 2019, the three cycles have started to diverge.
First and most important, global liquidity started to ease in response to the Fed’s triple pivot on the interest rate path, the balance sheet, and its inflation-targeting strategy. This was likely the main driver for the rebound in risk assets since the start of the year. 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.
Second, while clear signs of a rebound are still lacking, the global business cycle has likely stopped deteriorating. China’s purchasing manager indices (PMIs) ticked up in March, the European PMIs have been bumping along the bottom in recent months, and advance estimates of first-quarter U.S. GDP came in higher, year-over-year. 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.
Third, while global liquidity conditions have started to improve and economic growth looks set to pick up, the political cycle could yet deteriorate further this year. A trade deal between the U.S. and China is likely but appears to be largely priced in. 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. 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.
Taken together, with markets now fully priced for the Fed’s triple dovish pivot, the global business cycle having bottomed but unlikely to produce fireworks in the remainder of the year, and populism likely to reveal more of its ugly face in the coming months, global risk assets will most likely lack a clear direction this year and could become more volatile again.
Read PIMCO’s latest Cyclical Outlook, “Flatlining at The New Neutral,” for further insights into the outlook for the global economy along with takeaways for investors.
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.