Apart from the obvious geopolitical threat emanating from North Korea, the most important macro uncertainties – ‘the ABCs of caution’ – are the ageing U.S. economic expansion, the coming
end of central bank balance sheets expansion, and China’s political and economic course following the party congress.
On aging,as the U.S. expansion matures and slack in the labor market keeps eroding, we expect GDP growth to slow to a below-consensus 2% or less and core CPI inflation to pick up to 2% in the course of 2018. Thus, the
mix of nominal growth between real growth and inflation will become less favorable as disappearing slack makes it difficult to sustain the current pace of job and output growth. True, an acceleration of productivity growth would help,
but does not seem to be in the offing as business investment outside energy remains moderate. A Federal Reserve that is fixated on the Phillips curve will likely raise the policy rate two or three times between now and the end of 2018
– less than the four hikes the Federal Open Market Committee (FOMC) currently foresees but more than the extremely shallow rate hike path that markets price in right now. Thus, the front end of the U.S. yield curve looks vulnerable.
Regarding central bank balance sheets, the market has so far taken in stride the Fed’s plans to begin the process of normalizing its balance sheet in October as well as the European Central Bank’s (ECB)
hints at tapering its bond purchases next year. But don’t forget that there is virtually no historical precedent for major central banks actively reducing their balance sheets. Thus, the impact of the Fed’s balance sheet
unwind on the term premium and other risk premiums is unknown, especially as it will coincide with a period of uncertainty about the future Fed chair and the composition of the Board of Governors. This is one reason for us to be slightly
underweight duration and to expect a steeper yield curve.
As regards China, our forum debates centered on the implications of the more centralized and concentrated leadership that is likely to result from the party congress in October. One view, as stated above, is that the
new/old leadership will focus on further suppressing economic and financial volatility through a combination of continued leverage expansion, financial repression including tight capital controls and imposition of supply discipline
in commodities industries. If so, unlike in 2015–2016, China would not be an exporter of volatility to global financial markets. While this is a possible outcome, another distinct possibility is that the likely consolidation
and concentration of power opens the door for significant and surprising policy changes, including major reforms affecting state-owned enterprises (SOE) and forced deleveraging, which would weigh heavily on growth and could lead to
more tolerance for currency depreciation. This could potentially be signaled by a highly symbolic shift, such as the leadership dropping the growth target. Such changes, or the fear thereof, have potential to disrupt global markets.
In addition, a more assertive China in foreign affairs under a “paramount leader” President Xi Jinping raises the risk of an escalating trade conflict in case the U.S. administration decides to get tough on trade policy.