A continuation of last week

An American lead

United States growth continues to outperform both Europe and Japan by a significant margin. GDP growth since 2007 and for the projected continuation of 2018 has been 17.1% for the US, 11.6% for Europe, and a mere 6.7% for Japan. The American lead has most recently been a result of Tax and Regulatory cuts, while Europe has been held back by a variety of problems including a debt crisis. Additionally, U.S. labour and inflation rates remain extremely robust.

Therefore, America and the Federal Reserve could decide to slow the unconventional growth and arrive at a level at a level Ray Dalio[1] describes as a “beautiful normalization” by continuing to increase interest rates.

How did the financial markets react?

European and Japanese markets are regarded as less buoyant than their American counterparts. ‘Buoyancy’ describes equity and commodity markets with rising prices and considerable signals of strength. Even following the Fed’s raise, American stocks are performing notably better than those in other major economies. The effect on the global financial system may result in unwanted consequences for the next quarter and beyond.

Continued growth with high interest rates is resulting in a bolstering of the US dollar. This only worsens the existing trade tensions and could potentially result in new required concessions from, and for trade partners.

Emerging financial markets would struggle significantly more under these conditions if continued. High dollar valuation would lead to currency turmoil, higher borrowing costs, and a more difficult time dealing with existing debt. If this were to continue in the longer term, it could mean lower economic growth, unstable levels of inflation, and increased exposure towards financial vulnerabilities.

Would European & Japanese growth stabilize the future?

A more globally balanced rate of growth among the developed world would reduce pressure on foreign exchange markets and interest rates, opening the door to more normal and stable monetary policy, particularly benefiting emerging markets.

The ideal solution would thus include Europe and Japan catching up to the US. If instead America falls back to rates similar to others, the implications on a global scale would be more negative. This would mean a weakening of a global growth engine, intensified trade tensions due to more desperate parties, and a further polarization of the current political landscape.

Recommendations for Asset Managers in the short and long term

With such asset price discrepancies between America and Europe, the initial impulse would be to make ‘anti-divergence’  based investments. This would be recommended for the next few weeks of the remaining quarter, as the existing growth divergence may even intensify.

However, the longer the aforementioned trend continues, the higher the probability of a ‘regime break in markets’. A regime refers to a period where the data points of an economy follow a similar structure; a change or break would thus involve a change in the structure of the existing data sets. The below econometric model indicates how these regimes can be identified. Simply put, they are the financial version of very long trends.

This ever-increasing risk of a regime change in the long term allows potential investors to take one of two approaches towards risk. The risk reduced strategy would be to continue to bet on the underwhelming performance in Europe and Japan and bet for the US. Alternatively, investors can choose to bet against the current regime and diversify their portfolios in favour of expected growth in Europe and Japan.

[1] For more information on Ray Dalio, please visit https://www.principles.com/big-debt-crises/