Market Perspectives: Five-Year Outlook

Policymakers pull the punchbowl (30% probability)

Federal Reserve building

The U.S. Federal Reserve’s job is to “order the punch bowl removed just as the party is really warming up.” So said William McChesney Martin, the Fed’s chairman during the 1950s and 1960s. The idea is that central banks should tighten policy before inflation pressures get out of control. Timing is key here: tighten too early and recovery may be choked off, tighten too late and inflation pressures could require an aggressive response that pushes the economy into recession.

Chart 12: Bad things happen when policy is too lose for too longOur base case scenario remains one of balanced and sustainable growth but we have reduced the probability from 70% to 60% compared with last year, simply because the economic cycle is more mature and the scope for further non-inflationary growth is somewhat smaller.

The risk of a downside scenario is correspondingly greater. In this scenario, we are concerned that there will be policy errors. Past monetary policy may have over-stimulated the markets, which could stoke inflation, which might then coincide with the quantitative tapering and exaggerate the impact, hastening first the U.S., and then the rest of the world into a recession.

Chart 13: Fed Policy – Unemployment Risks

Alternatively, there is the risk that central banks will take a more aggressive approach, tightening the expansionary policy too quickly, triggering an economic downturn, a squeeze in profits and a recession.

Our downside scenario: Policymakers pull the punchbowl

Loose monetary policy, both in the U.S. and abroad, has been abundant over the past eight years. Will the fed pull the punchbowl and end the party?
 
Listen to the full episode here.

The exact mechanics of the balance sheet normalization are also going to vary between regions, and with mixed results. While generally the central bankers in developed markets seem to be speaking in unison, we are seeing an increasingly hawkish stance dominating and interest rates coming under upward pressure for the first time in a number of years. In particular, this could have negative implications for the peripheral eurozone economies such as Spain, Italy, Portugal and Greece as they see their borrowing costs rise significantly from current levels, resulting in a debt / GDP trajectory that appears far less sustainable in the longer term. In the U.S., the U.S. Federal Reserve’s (Fed) reduction of U.S. treasuries and mortgage backed securities could put mild pressure on housing as mortgage rates increase from current low levels.

Populism and protectionism

We’ve already identified the risk that populism could lead politicians to reach for the protectionist weapon, triggering retaliation and a downward spiral of recession and global trade implosion.

The early signs of this are being played through in very open rhetoric, promoted and amplified via the world media, best seen in Trump’s all too public addiction to Twitter.

Undoubtedly, trade disputes will continue to erupt but it is the extent to which they lead to punitive action and provoke strong retaliation that matters for the world economy.

Within Europe, the recent election surprise in Germany could have a negative impact, as Chancellor Merkel is forced to consider tighter controls on immigration and to focus on strengthening the European Stability Mechanism (‘ESM’), possibly disappointing France in the process.

Chart 14: Fed Policy - Even with Inflation Below TargetInflation remains public enemy number one

As we discussed in our base case scenario, there is concern that the U.S. economy overshoots full employment. To avoid an overshoot, policymakers will need to slow down growth but if the momentum in the economy is too strong this may require an aggressive monetary response.

Run out the guns

In our second scenario, we place a lot of focus on the actions of the policymakers, including politicians and global leaders.

There remains a serious concern that the leaders’ rhetoric spirals out of control in a tit-for-tat exchange e.g. between Trump and Kim Jong-un.

At its simplest level, this is a distraction that the world could do without, given the number of tangential regimes that would be caught up in any serious escalation. At its extreme, it could catapult the world into a volatile confrontation in a region where there are other existing territorial disputes still simmering involving China, Taiwan, Japan, U.S. and Russia.

New threats from new technology

The final unknown that we consider in our second scenario is the impact of disruptive technology and the number of new industries and products emerging that are challenging the existing market leaders.

 

Red Circle Arrow IconBack to the full Five-Year Outlook

 

Better conversations. Better outcomes. podcast

Looking ahead: 2018 Five-Year Outlook

Jon Adams, Senior Investment Strategist & Portfolio Manager at BMO Global Asset Management, joins our latest episode of the Better conversations. Better outcomes. podcast to discuss the importance of the forum, the three scenarios that could drive markets in the next five years and what each could mean for investors and portfolio positioning.
 
Listen now

 


 

Additional scenarios and investment implications

Strategic asset allocation
View the investment implications on equities, fixed income, alternatives and currencies for all three of our scenarios in our over- and under-emphasis table.
Steady as she goes (60% probability)
Our base case scenario, in which we see the global economy continuing to enjoy steady growth with modest inflation, despite the slight headwinds created by the gradual withdrawal of quantitative easing and higher interest rates.
Perfect policy prevails (10% probability)
Our upside scenario takes a look at what happens when the policies all go according to plan and the policymakers get it right.

 


 

You are now leaving the BMO Global Asset Management web site:

The link you have selected is located on another web site. Please click OK below to leave the BMO Global Asset Management site and proceed to the selected site. BMO Global Asset Management takes no responsibility for the accuracy or factual correctness of any information posted to third party web sites.

Thank you for your interest in BMO Global Asset Management.

You are now leaving the BMO Global Asset Management web site:

The link you have selected is located on another web site. Please click OK below to leave the BMO Global Asset Management site and proceed to the selected site. BMO Global Asset Management takes no responsibility for the accuracy or factual correctness of any information posted to third party web sites.

Thank you for your interest in BMO Global Asset Management.

You are now leaving the BMO Global Asset Management web site:

The link you have selected is located on another web site. Please click OK below to leave the BMO Global Asset Management site and proceed to the selected site. BMO Global Asset Management takes no responsibility for the accuracy or factual correctness of any information posted to third party web sites.

Thank you for your interest in BMO Global Asset Management.

You are now leaving the BMO Global Asset Management web site:

The link you have selected is located on another web site. Please click OK below to leave the BMO Global Asset Management site and proceed to the selected site. BMO Global Asset Management takes no responsibility for the accuracy or factual correctness of any information posted to third party web sites.

Thank you for your interest in BMO Global Asset Management.