The divergence among economies, and the asset-price dispersion that has come with it, remains one of the key global issues for policymakers and investors this year. The phenomenon isn’t sufficiently appreciated, even though it has material impact on benchmark market relationships and leads to feedback loops between financial and economic influences.
Yet it will continue to be important, defining not just the immediate future but also raising important questions about the kind of convergence that is likely to follow.
Global economic patterns, especially among advanced countries, tend to be dominated by correlation rather than divergence because of the depth of cross-border trade and financial linkages. This was the case during the financial crisis and its aftermath, and right up to the beginning of this year.
After a major collapse in gross domestic product and employment, the majority of advanced countries got stuck for an unusually long period in a new normal of low and insufficiently inclusive growth. This gave way in the second-half of last year to a synchronised pickup when every major economy, except for the UK, experienced an acceleration of growth, as did the vast majority of emerging countries.
By the April 2018 meetings of the International Monetary Fund and World Bank, conventional wisdom had fully embraced the notion of a synchronised pickup in global growth. Yet the underlying dynamics were becoming more divergent for two principal reasons.
First, the pickup was neither coordinated nor deeply synchronised. Instead of reflecting a set of common powerful factors, the phenomenon was the result of different drivers — from a policy-induced growth acceleration in the US to the less durably powerful effects of natural economic and financial healing processes in Europe.
Meanwhile, the more systemically important emerging economies were recovering from one-off shocks, such as demonetisation in India, the commodity price slump in Russia and political turmoil in Brazil.
Second, differences in underlying growth drivers were widening. In the US, fiscal stimulus was turbocharging the effects on consumption of rising household income.
Corporate investment was also boosted by improving business sentiment. By contrast, neither Europe nor Japan seemed able to capitalise on the growth pickup.
Regional tensions, an insufficient focus on policy in many countries and uncertainty about the global trade regime were starting to dampen both business and consumer confidence in Europe. This was followed by growing concern about Italy and the adverse spillover effects of interest rate hikes in the US, as well as the gradual reduction in the European Central Bank’s $4.5 trillion (Dh16.52 trillion) balance sheet.
In Japan, the government continued to struggle to implement the decisive structural reforms needed to overcome deeply embedded growth constraints.
This economic divergence has had a significant impact on markets.
Since the start of this year, the yield on the benchmark 10-year US Treasury bond has risen by 80 basis points to 3.21 per cent, while the yield on the German 10-year bond has remained essentially unchanged at just over 0.4 per cent. The current differential of almost 280 basis points is a huge historical outlier.
Dispersion has also been the name of the game for two-year bonds, where the yield differential currently stands at over 350 basis points as the German notes persist in negative yield territory. At the same time, the dollar has strengthened by almost 5 per cent, as measured by the DXY index.
Dispersion in stocks
Then there is the eye-popping dispersion in stocks. So far this year, the S&P index has outperformed the German DAX by 14 percentage points and the EEM index for emerging markets by even more. Again, these constitute notable historical outliers.
The greater the divergence in asset-price performance, the more the financial media calls on investors to opt for the convergence trade. And the time for such convergence will come, but — I believe — not just yet.
Extreme valuations may be necessary for convergence, but they are not always sufficient. At times of significant economic and political fluidity, such as now, a catalyst is often needed. The most likely source today is policy.
Yet it is hard to see either Japan or, more importantly, Europe deliver this kind of impetus in the next few months.
As the German chancellor, Angela Merkel, confirms her intention not to stand for re-election and President Emmanuel Macron of France faces headwinds in implementing elements of his domestic reform agenda, the hope of a French-German led European revival is giving way to the reality of a region dealing with notable tensions and fragmentation pressures that go well beyond Brexit.
Italy and the European Commission are engaged in a skirmish over budgetary issues. Inward-looking governments in the central and eastern parts of the regional bloc are defying a growing number of European principles and behavioural guidelines.
Differences of view over relations with China and Iran tend to increase the challenges to regional coherence, which are amplified by the tough approach that the US is adopting toward both countries. And very few national governments appear willing, let alone able, to ramp up their pro-growth policy agendas.
Meanwhile, the external growth stimulus from China is slowing.
Monetary policy won’t overcome these impediments. Indeed, we have entered a stage when systemically important central banks, which had a calming influence, will likely exacerbate volatility.
Already, the ECB plans to terminate its programme of large-scale asset purchases, a key element of its stimulus, at the end of the year. But the policy gap with the Fed will not narrow much given the US central bank’s determination to maintain a relatively aggressive rate of rate hikes as its balance sheet gradually shrinks.
Meanwhile, the People’s Bank of China seems conflicted about its exchange-rate policy.
All of this suggests that while historically unusual economic and policy divergence has already created some atypical dispersion among asset values, it may not yet be the best time for investors to position themselves aggressively for convergence.
This is particularly true for portfolios and funds that are subject to outflows and/or are ill-equipped to tolerate sudden bouts of volatility. And when the time comes for convergence — probably in the first-half of 2019 — there will be a lot of ways to translate this trade in investment portfolios.