As investors grapple with an array of scenarios with unpredictable outcomes, we retain our modest caution towards risky assets.
At our last strategy week, during which LGIM’s investment teams debate the macro and market environment, a unifying theme emerged: investors are at present particularly sensitive to event risk.
To a certain extent, of course, investors always are. But the point about this moment, at this period in the economic cycle, is that the event risk stemming from issues such the US-China trade hostilities or Brexit is fiendishly hard to price.
Here’s a chart we discussed showing the probability assigned to various events (the vertical axis) against our view of their relative impact on global growth (horizontal axis). Clearly, these events are moving fast and probabilities are evolving, but this gives you an idea of the wide spectrum of outcomes.
Of all these scenarios, the US-China trade war could have the biggest impact on global growth, either to the upside or downside. Yet many of the others plotted on the chart could also sway the global economy in either direction. Given these highly unpredictable outcomes, and the fact that market liquidity could deteriorate as the year end approaches, many investors are understandably hesitant to take large positions.
More broadly, we see downside economic risks as being elevated, with the odds of a global recession at around one in three. It’s hard to argue this downside risk is fully reflected in current equity or credit market pricing, in our view.
Of course, positive geopolitical developments could result in outsized market moves in the other direction. And global central banks are likely to maintain or increase monetary policy support, certainly in the event that those downside risks crystallise.
In this context, we discussed recent upward surprised to US inflation – could the US Federal Reserve (Fed) be constrained by rising prices, not able to adequately support growth? It’s important to note that the Fed focuses more on core PCE inflation than headline CPI. And as the chart below highlights, PCE is not expected to accelerate far beyond the 2% target. In addition, due to ‘average inflation targeting’, we believe a period of above-target inflation is unlikely to prevent the central bank from easing if required.
Elsewhere, Chinese stimulus continues to be modest at best, but we think they would step up support should the property market start to materially weaken.
Finally, the past few days have seen the start of the third quarter’s earnings season, with the big US banks leading the charge. There have been a few decent beats, but also a couple of misses.
In aggregate third-quarter US earnings are likely to be pretty flat versus last year, which is not bad considering the boost companies received from the Trump tax cuts at the beginning of 2018. But we will probably need to see a return to earnings growth next year or else equity investors will become nervous.
This will be influenced by how issues like trade talks play out – so we return again to unpredictable geopolitics and investor sentiment. This explains why, in our overall positioning, we retain our modest caution towards risky assets.