‘I really just see the bigness of it all.’ – President Trump
Stock markets have had a blistering first half of the year amidst brightening prospects for the world economy and a political climate less fractious than feared. Bond markets have been helpful too, with falling inflation expectations part of the force that has driven bond yields around the world lower. What can we expect from the second half of the year?
In our view, the sharp bond market rally seen over the last quarter represents an overreaction to a likely temporary lull in inflation alongside an entirely predictable US congressional logjam. On this week’s evidence, central bankers in the US and Europe rightly remain keen to wean their patients off emergency monetary support. Even assuming some form of negative risk premium at the short end of government yield curves, the path of implied rate rises now looks too meek for an increasingly normal world economy.
If that path rises to meet our broad expectations and even some positive risk (term) premium re-emerges, equity markets around the world may find the going tougher than they have found it in the first half. This should be the case anyway, in truth. The investor community is less obviously gloomy about the economic and political prospects for the world – the health of the global economy has become less debatable as past turbulence in the dollar and oil prices has gradually relaxed its grip on various economic statistics, including corporate earnings. Stock markets are simply pricing the outlook for the world economy more sensibly than they were at the beginning of 2016.
However, even though expectations look closer to reality and bond markets less friendly, we still see stocks continuing to reward investor pluck. The steady earnings growth forecasted by surveys, consistent with the increasingly rosy health of the US and global business cycle, is central. Investment is also picking up, suggesting that global demand has become less reliant on the broad shoulders of the developed world consumer.
Meanwhile, the emergence of a plausible upside scenario in Europe, distinguished by a more collegiate political backdrop, a healthier banking sector, and even meaningful steps forward in the construction of a credible fiscal and political architecture for the euro, should help drag the whole distribution of outcomes for European risk assets higher.
Of course, not all risks have disappeared, just those that mistakenly preoccupied many at the beginning of the year. The primary risk for us now centres on the bond market and monetary policy. Central bankers have a wobbly tight rope to tread, perhaps buffeted by a bond market that has become too used to falling yields. Remember that in around eight centuries of history, only two previous episodes – the rally at the height of Venetian commercial dominance in the 15th century, and the century following the Peace of Cateau-Cambrésis in 1559 – recorded longer continued risk-free rate compressions. Meanwhile, in terms of scale, only the rallies following the War of the Spanish Succession and the election of Charles V as Holy Roman Emperor can trump the bond run seen since Paul Volcker’s ‘war on inflation’.
It may be wrong to assume that this historic bull run in interest rates ends in benign fashion, as we currently do. There are certainly scenarios where central bankers, still locked in post financial crisis fire-fighting mode, react too slowly to the signs that heat is rising in the world’s important economies. To that end, the more resilient hawkishness on display this week from the world’s central bankers should be a source of reassurance rather than alarm.