2018: more risks lie ahead than expected next year

2018 will not just be the natural extension of 2017, even if growth is still robust and monetary policy are set to remain fairly accommodative in the absence of inflation.

2018 will be different because expectations will change, as the economic situation is changing radically. Optimism reigns across the various institutions, as we have recently seen in the IMF’s half-year data. Business leaders also have a more positive outlook on their environment: in September 2017, French manufacturing sector industry leaders’ confidence on the economic situation hit its highest point since October 2000. Companies are seeing a change in economic pace. Markit surveys on the manufacturing sector are all in positive territory. This assessment of the immediate future will lead to more jobs and more investment, which will underpin growth, as we witness a virtuous situation, which is poised to satisfy all onlookers: the uncertain past is getting further and further away and now is the time for revival.

Yet actual change will not be so instantaneous, as the economy does not have a deterministic profile.
The macroeconomic situation is gradually getting back to normal, but we are set to see a new pecking order between now and the future. Central banks have so far managed to keep things on track, and this led to major monetary policy divergence from traditionally accepted practices. Central banks’ ambition was to make future holdings worth less than their present value, with the aim of encouraging economic players to spend sooner rather than later. Low and even negative interest rates meant that there was little incentive to keep wealth to use in the future, thereby encouraging investors to spend or invest now. This period is coming to an end, particularly in the euro area. After almost ten years on a downtrend, private domestic demand (domestic demand less public spending) in the second quarter of 2017 got back to record highs unseen since 1Q 2008.
It took a very long time to get back to a certain degree of normality, which is why economic players’ projections took a long time to take an upturn again. This situation and its perception justified the ECB’s strong monetary accommodation and similar policies from other central banks outside the euro area. It was vital to trigger and drive more sustainable growth and expansion momentum in the long term.

Timeframe for projections will be decisive

We are now probably close to the point when projections start to return to normal as growth is finally gathering speed worldwide. The future will no longer carry less value than the present in the way we have witnessed of late, and interest rate trends, which are an indicator of the balance between present and future value, will no longer remain on the track we have seen in recent years.

So the difficulty in 2018 will be the shift from an optimistic view on growth and jobs, to a change in the decision between spending today and investing in the future. This normalization should lead to higher long-term interest rates.

The crux of the matter is how the central banks are going to manage these new expectations. A hasty hike to interest rates would radically transform allocation between financial assets, particularly between risky and risk-free assets. So far, low bond yields encouraged investors to increase their proportion of risky assets in order to hope to achieve decent yield on their portfolios, so if we expect an increase in bond yields, even if it’s not in the very near future, investors’ allocation will change.

The heart of the matter will be the transition: how quickly will these expectations change and how will they alter investors’ portfolio make-up? This may upset the apple cart as the stockmarkets are expensive. An excessively fast change to interest rate projections would have a major and far-reaching effect on stockmarket showings, as investors would forsake the asset class and a major stockmarket correction could not be ruled out. This situation would not be welcome as central banks only have limited leeway to address the situation. During the 1987 Wall Street crash almost exactly 30 years ago (19 October), there was virtually no macroeconomic impact as the Fed very swiftly and sharply cut back its intervention. Today’s central banks would have virtually no power to deal with a crash in the current environment. The Fed funds rate currently stands at 1.125%, the Bank of England’s rate is 0.25%, the central bank rate in Japan comes to -0.10% while the ECB’s Main Refinancing rate is 0%. These rates are already so low that cutting them to 0% would not generate enough liquidity to rebalance the market.

A stockmarket crash cannot be allowed to happen: the central banks would not have the wherewithal to deal with it.

This is why central bankers are going to steer their communication much more extensively in 2018. On the one hand, we are set to see more positive expectations on the future with the idea of macroeconomic normalization in the background, while on the other hand, central banks cannot spontaneously confirm this change in expectations. If their intervention is inadequate or careless, risks would emerge as expectations would be pushed upwards. This is why the appointment of a new Fed chair is a cause for concern if the newcomer does not have the necessary clout to influence the market and investors and assert the Fed’s credibility. The four potential candidates to replace Janet Yellen do not offer sufficient assurance in this respect. Meanwhile, in the euro area, the ECB and Mario Draghi will have to maintain QE on a pace that can address these rising anticipations.

2018 is set to be fascinating: it could be a year of high risk or the starting point for a new era of growth. Worldwide momentum will hinge on central banks more than ever, which is reassuring but also terrifying.

Philippe Waechter – Chief economist – Natixis Asset Management