Livewire Christmas Cracker #11: Is 2018 the year the porridge turns cold?

In our new 'Christmas Cracker' series, each morning through to Christmas we will bring you a top insight for 2018 from one of our contributors. Today’s insight is by Vimal Gor, BT Investment Management. 

2017 proved a goldilocks year for risk assets with subdued inflation, persistently low volatility, accommodative monetary policy settings and resilience to political upsets.

We entered the year with an optimistic attitude which the market attributed to US policy promises. However, the real turn in leading indicators of economic activity took place six months earlier, well before Trump was afforded a decent chance of an election victory. We believe this was tied to China restimulating its economy with a sizeable credit expansion, which in turn flowed through to the rest of the world.

Going into 2018, we believe a shift in the Asian giant’s focus from the quantum to the quality of growth holds the biggest ramifications for the global economy.

We are entering a new era of Chinese expansion where the old model that relied on construction, infrastructure and housing will increasingly pivot to consumption and more sustainable longer term sources.

To put the size of the old economy into perspective, China consumed more cement in the three years to 2013 than the US did during the entire 20^th century.

Meanwhile, consumption’s share of GDP is only 39% versus 60% for the OECD. To swing this percentage for the world’s second largest economy will require change on a grand scale and the country’s leadership signalled this year that they are prepared to tolerate some shorter-term pains, which raises significant risks for the rest of the world.

“Going into 2018, we believe a shift in the Asian giant’s focus from the quantum to the quality of growth holds the biggest ramifications for the global economy.”

This risk is exemplified by trade data in Europe. The region has witnessed an impressive pickup in GDP growth from 1.9% year-on-year to June 2016 to 2.8% to June 2017. The largest component of this increase was net exports, responding to stronger Chinese demand. Going forward, this tailwind is likely to fade and an expected swing in fiscal spending in the region may do little to replace it. Similarly in the US, the new Administration’s promises for a new wave of infrastructure spending have yet to be realised.

This becomes more problematic when considered alongside an unprecedented global normalisation of monetary policy. We acknowledge global liquidity is still expected to expand in 2018, but at a slower pace. By 2019 it will be the first contraction since the GFC.

This is significant for markets because of the potential impact on volatility and asset prices. The quantitative easing that effectively created a put under asset prices and crushed volatility in recent years is in the process of being removed. In turn, risk assets that typically have less liquidity, like high yield credit, will be left more vulnerable. As such, it will be increasingly risky to rely on such areas to boost returns and more diversified sources of alpha will be needed compared to prior years.

“To put the size of the old economy into perspective, China consumed more cement in the three years to 2013 than the US did during the entire 20th century.”

Overall, we believe the pivot in Chinese growth policy, which poses greater risks to global growth over the short-term, coupled with a concerted monetary normalisation and the threat of increased volatility suggest a defensive fixed interest allocation should be a critical component of an investor’s portfolio in 2018.

Written by Vimal Gor, Head of Income & Fixed Interest, BT Investment Management.