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Brace for a 30% correction next year, warns LGIM

Brace for a 30% correction next year, warns LGIM

The end to central banks’ quantitative easing (QE) programmes will cause an asset price correction next year with more than 30% wiped off valuations, predicts LGIM chief investment officer Anton Eser.

Eser said 2018 would mark the end of the eight-year bull market that has pushed shares and bond prices to record highs.

Although he noted the ‘synchronised global growth, a pick-up in global earnings and subdued inflation’ as well as central banks’ ‘relatively dovish’ stance, he warned there was a big risk looming.

This risk comes from global central banks removing and cutting back QE programmes, which Eser said would create a ‘big change’ over the next 12 months.

‘If you take what’s expected in terms of gross issues in the government bond market across major economies… [you have] tightening in the US and a rundown of the European Central Bank’s QE programme, and what the Bank of Japan will do with their QE,’ he said.

‘We have calculated what we see as happening in 2018… where there’s been issues is in the big amount of debt being taken out of the system with QE, now that will change.’

He said the supply of government bonds would switch from net $300 billion taken out of the market to net supply of $500 billion.

‘The net supply will crowd out the private sector,’ he said. ‘QE forced people to buy investment grade bonds and equities and in 2018 that shifts.’

It is not just the scaling back of QE that will push a correction, Eser argued. He said the reduction in credit in China as it tries to get a grip on its shadow banking problem would also have an impact.

‘Shadow banking has been very important in terms of growing credit,’ said Eser. ‘It has pushed up bond yields in China.’
He said the conditions that created tailwinds for credit and asset prices generally would move to ‘head winds’.

‘As we are looking into 2018, this low volatility, high asset price environment, there is a potential trigger for volatility. Timing it is very difficult but sometime next year there will be a pick-up in volatility and it will lead to a repricing of the risk premium.’

Eser said the scale of the correction was hard to predict but that price-earnings ratios on US equities were at least 20% to 30% more expensive than historic norms so a correction of the same degree should be expected.

‘When you go through any type of repricing you always overshoot on the downside,’ he said. ‘It could be well in excess of 30%.’

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