What a difference six months makes. After the exuberant highs of last year, the mood in financial markets turned quickly in 2018.
Volatility spiked sharply as early as February, with the widely-tracked CBOE Volatility Index surging to 37.32 on February 6, after settling between 10 and 12 range through much of 2017.
That happened against a backdrop of a shift from quantitative easing to quantitative tightening as the US Federal Reserve began normalising its balance sheet in October 2017, followed by the European Central Bank initiating tapering measures in January 2018.
Adding to the stress was increasing trade frictions between the US and the rest of the world. In its latest salvo, the US slapped a 10% tariff on $200 billion of Chinese imports, just days after imposing tariffs of 25% on $34 billion of Chinese imports.
The US and China have engaged in a tit-for-tat implementation of tariffs since March, but other jurisdictions, such as the European Union, Canada, and Mexico have all been affected. All of them have anounced their own set of retaliatory tariffs in response.
Could the situation get worse? Against an increasingly worrisome economic climate, we asked two wealth managers, an emerging market debt fund manager, and a multi-asset strategist what they anticipate to be the worst-case scenario for markets in the second half of 2018.
The responses below have been edited for clarity and brevity.
Bryan Carter, head of emerging market debt
BNP Paribas Asset Management, London
We believe that a US recession is the most clear market risk. The US cycle is ageing and ultra-low unemployment rates and rising inflation spell potential for the Federal Reserve to be forced to over-tighten and tip the US into recession. The US yield curve and other indicators are already pointing to the likelihood of this scenario in the next few quarters.
We believe a US recession would be abominable for emerging market assets, given the flight to liquidity that would drive global investors into dollars and out of emerging market currencies, and the fact that US growth has become such a key engine for the global economy that it could easily cascade into a number of economies also entering recession, including in emerging markets.
Given high fiscal deficits in many countries, the large run-up in government and private sector debt over the past decade across emerging markets, and still relatively easy monetary policy in many markets, such a global recession would not be easy to address through traditional tools. We are especially worried about the potential for an economic crisis to become a debt crisis in several particular markets.
We place the odds of a US recession at 20% this year, 50% by end 2019, and 80% by end of 2020.
Nick Samouilhan, solution strategist, multi-asset division
T. Rowe Price, London
When people think about events that could impact markets, they often focus on very high-impact but very low-probability events (such as wars) or on geopolitical issues such as trade wars. These often miss the point from a practical perspective of running portfolios; investors spend far too much time on things that are interesting but unlikely and unimportant.
Instead, investors should concern themselves with the more boring but more likely and relevant issues -- identifying those small bushfires that could become blazing infernos.
For me, one of these bushfires is the steady rise in inflation globally that sits uneasy in a world of low bond yields. The risk is not a sudden spike of inflation, but rather a slow but consistent rise in inflation to more normal levels. This is very possible, if not likely, in a world of globally reinforcing growth and tight labour markets.
There is an entirely reasonable scenario for the second half of 2018 that sees a slow pick-up in inflation suddenly sparking a process of self-reinforcing corrections propagating through markets, leaving many portfolios without protection and incurring large losses.
Under this scenario, an innocuous inflation data release shows that inflation is returning, reinforcing a market narrative that bond yields are too low. Markets then react to price in higher inflation through higher yields, with bonds selling off. These higher rates then cause equities to fall given the rise in discount rates. These combined losses cause investors to de-risk, with these redemptions leading to further losses on equities and bonds. Importantly, from a portfolio perspective, the historical negative correlation between equities and bonds becomes positive instead, removing at a stroke the key method most portfolios use to protect against market falls.
Tuan Huynh, CIO and head of discretionary portfolio management, Asia-Pacific
Deutsche Bank Wealth Management, Hong Kong
The key event in [the second half of] 2018 is the US government’s 10% import tariffs on $200 billion Chinese products. The implementation date would be September to October this year, if it passes the public hearing. It would cover a wide range of consumer products, including technology products. If it were implemented, it would mark significant escalation of the trade tensions between the US and China, two of the world’s largest economies.
The impact of this event will be wide. It may lead toretaliation measures from China, which may push the global economy into protectionism mode. This could lead to equity market falls, because of weaker business confidence, disruptions to global supply chains and lower corporate earnings, especially in the information technology sectors such as tech hardware. Besides, the protectionism policies could lead to higher inflation in the US, which could prompt the Federal Reserve to raise rates faster. Faster-than-anticipated Fed hikes may hurt the bond markets, both in developed markets and emerging markets.
In our base case, we think the import tariffs on $200 billion Chinese goods will not be implemented. We think China and the US will negotiate to find solutions. We think China could, in general, take a more accommodative approach on the trade tensions with the US, given it has been a beneficiary of globalisation. We think China could increase its purchases of US products and open up its domestic market further to reduce the trade imbalance. Besides, we think the negotiation between China and the US would be easier after the mid-term election in the US in November.
Yifan Hu, regional CIO and chief China economist
UBS Global Wealth Management, Hong Kong
China's potential credit crunch is a market concern. Pressures on the banking balance sheet under the new [asset management regulations] and coming [wealth management] regulations, and the rising non-performing loans, are both concerns.
No systematic financial crisis [is imminent], but rising defaults in certain sectors (overcapacity sectors, traditional manufacturing, traditional retail, and local government financing vehicles) and certain regions will become a "new normal" and place pressures on the credit market. “Loose liquidity but tight credit" is expected to continue.
Policy makers have been monitoring financial market volatility and banking pressure, as well as their potential spill-over effects, amid China’s deleveraging campaign, regulatory tightening, and worsening China-US trade frictions. The central government continues to seek a balance between stability and deleveraging. While the market should not underestimate China’s determination to push on deleveraging and regulatory tightening, it appears likely that the pace and rhythm of its implementation could become more mild.
[We expect] incoming softening policies, including softer approach to [wealth management products], subtle tone changes by the policymakers, [reserve requirement ratio] cuts, and more fiscal supports on infrastructure investment in particular.