By ETF Securities – We now stand at a tipping point for a new generation of commodities driven by intertwining technologies among the themes of energy efficiency, automation, and climate change likely to be central for commodities demand. In our 2018 outlook we explore a range of disruptive themes, from commodities to Bitcoin and green bonds to central bank policy.
The world is in a synchronous growth phase at present, supported by massive central bank stimulus. However there are indications that developed markets are likely close to their cycle highs, and a period of slower growth potentially lies ahead.
While we think that the world economy will escape a significant upset in 2018, there remain formidable tail risks. Recent polling in Italy highlights a resurgence in popularity of the populist 5-Star movement and Germany is currently unable to form a stable coalition primarily due to issues associated with populism; it may have subsided in Europe but it certainly remains a thorn in its side. In emerging markets there is a risk of escalation in the Saudi/Iran proxy war, prompting a potential oil price shock, while there are presidential elections in both Mexico and Brazil where populism is prevalent. And finally, the unwinding of monetary policy brings risks to both bonds and equities, likely renewing appetite for assets classed as alternatives.
There are three big questions for investors in 2018: Can major central banks deflate the global bond balloon without derailing global expansion? Can global equity markets continue their stellar rally? And will China keep the commodity rally alive with the US Federal Reserve (Fed) tightening rates?
Deflating the global bond balloon
Major central banks learned a valuable lesson from the 2013 ‘taper tantrum’ in the US: prudent communication is crucial to forming investor expectations about the path for tighter monetary policy, maintaining market confidence and ensuring the market is aware that stimulus will not be sharply withdrawn. ECB President Draghi recently stated ‘Why discard a monetary policy instrument [forward guidance] that has proved to be effective?’ Comments such as this indicate that major central banks will remain very cautious in the removal of the vast stimulus provided by quantitative easing (QE) when the time is right.
With inflationary pressure only expected to be a burden for US policymakers, wide ranging asset purchasing programmes will continue to be a key feature of central bank policy in 2018. Although the balance sheets of most major central banks will continue to rise, a measured removal of accommodative policy in the US will allow policymakers to deflate the global bond balloon rather than see it burst.
The Fed is the only central bank that we expect to reduce its balance sheet in 2018. And although it appears that the Fed is finally becoming proactive by raising rates ahead of building inflationary pressures, 2018 will be a year of change. The top three Fed officials are relinquishing their posts and a non- economist at the helm raises the potential for policy mistakes. Indeed, Jerome Powell has never dissented in his time as a Fed Governor, a fact that doesn’t instil confidence that he can continue to forge a pioneering path. What the Fed does and what it should do are different things: hiking rates and reducing the central bank’s balance sheet are necessary to counter rising inflation pressure. While wage growth has been lacklustre in recent years, real wage growth has remained positive. In a strengthening jobs market, workers feel more secure, and as inflation begins to rise next year, there is likely to be a greater tendency for workers to request pay rises. If the Fed fails to raise rates three times next year, a scenario that is expected by the market, an adverse inflationary feedback loop, via wages, could become entrenched.
If the Fed does adjust policy to contain building inflationary pressures as we expect, the US Dollar (USD) is likely to grind higher in H1 2018. Divergent monetary policy is another supportive factor for the USD: as the Fed unwinds its QE, in stark contrast to other major central banks, it will engineer a modest steepening of the US yield curve.
Higher nominal interest rates, a steeper yield curve and the resultant stronger USD are likely to be impediments for significant upside in the price of gold. However, there are other factors in play: uncertainty over the ability for equity markets to continue their stellar rally has led investors to look for ways to hedge a potential correction. Although we expect the Fed to continue to tighten policy, we think the downside risks to gold prices are limited because real interest rates will remain depressed as inflation gains pace in the US. However, a shock event, such as an equity market correction, could force gold prices higher. On balance we see little change in gold prices in the coming year. Investors continue to be optimistic about gold despite the rising interest rate environment, we believe this is due to investors now seeing gold as an insurance policy from geopolitical concerns rather than investment.
Stretched equity valuations
Navigating the stretched valuations in both equity and bond markets and the potential pitfalls of low volatility will be a critical objective for investors in 2018. US Corporate margins will face headwinds from tighter US monetary policy and wages growth. As the US jobs market continues to tighten in 2018, wage pressures are likely to rise significantly and reinforce inflation momentum due to the need for businesses to increase prices in an attempt to preserve margins. Typically, at this point in the economic cycle, price earnings expansions leave markets much more vulnerable to corrections. This is most prevalent in the US where valuations are extreme on both an absolute and relative basis. We continue to see value in European and emerging market equities where economic growth seems more sustainable in the coming year.
The emerging market puzzle
Another potential consequence of tighter US policy is the negative impact on emerging market economic growth, and in particular China. Higher borrowing costs, input costs and currency volatility could be a threat to EM growth, as is potentially weaker revenue streams for commodity producers, vulnerable to a rising USD at a time of ongoing commodity supply-side destruction.
Miners Margins vs Supply/Demand
Source: Bloomberg, WBMS, ETF Securities as of close 22 November 2017
EM demand is also crucial for commodity markets as they represent 70% of industrial metals demand. In this respect, we expect any weakness in commodity prices to be largely offset by solid demand growth, again led by China. Although concerns remain over the build-up of debt, Chinese policymakers have continued to show a willingness to support the financial system with stimulus to ease financial conditions. We expect commodities to outperform, as investors look outside traditional asset classes to alternatives for better value; the global increase in infrastructure spending being a significant driver. Although commodities are a heterogeneous group, we expect the star performer for 2018 to be industrial metals (see Industrial metals likely to open to new entry points). This sector is likely to benefit the most from improving EM growth, at the same time we expect supply to remain in supply deficit in 2018 as the lack of investment in mining infrastructure continues to bite.
First published in ETF Securities’ Outlook 2018