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Over the course of 2016 there was a broad-based, synchronised pick-up in global growth. That increased rate of growth has been sustained through 2017, and for the first time in six years the IMF has revised up its global growth projection for the year ahead (Figure 1).
The pick-up in growth has come from a modest acceleration in the major developed economies, with the United States, Eurozone and Japan now all growing faster than the estimated potential rate of increase. While spare capacity has largely been eliminated in the US, monetary policy remains accommodative and growth therefore remains supported. In the Eurozone and Japan the recovery is less advanced and monetary policy highly accommodative. Amongst the emerging market economies, Chinese growth has stabilised after picking up in late 2016, supported by expansionary fiscal policy and continued rapid credit growth. That has supported growth in Asia and other regions that have China as a major export destination. The most notable improvement among emerging market economies, however, has been in Brazil which has finally emerged from a deep recession.
A combination of economic and marketbased indicators suggest that global growth is likely to be sustained around current rates over the coming months (Figure 2). Looking further ahead, we expect global growth of 3½-3¾ per cent in 2017 and 2018, a modest upward revision to our previous expectations.
With stronger global growth and the steady erosion of spare capacity, inflation pressures are expected to rise modestly. Following the collapse in headline inflation in 2014/15 (after the sharp decline in oil prices), 2016 saw inflation rates head back towards 2 per cent in the major developed economies (Figure 3).
While there has been some recent softening in those headline measures, particularly in the US, that is expected to be transitory. The risk of deflation has passed, and while it is unlikely that inflation will rise rapidly, the direction of travel should remain upwards so long as growth is sustained and monetary policy remains relatively accommodative. We expect US inflation to rise back to around 2 per cent by mid-2018, but see a more gradual increase in the eurozone and Japan. Inflation in the UK will probably peak next month, following the effects of the exchange rate depreciation in 2016, and should steadily decline thereafter.
The improvement in global growth, alongside modest inflation, has been accompanied by a marked decline in market volatility across a range of asset classes. Low market volatility has often been associated with low economic volatility and smaller than usual economic surprises. In the aftermath of the volatility that came with the financial crisis of 2008, central bank asset purchases also acted to supress market volatility, with major risk events causing only a brief disturbance in financial markets, followed by a return to calm.
More recently we have witnessed low economic volatility and continued asset purchases by the European Central Bank (ECB) and the Bank of Japan (BoJ). It is therefore perhaps not that surprising that market volatility is low. In recent decades low equity market volatility has tended to be associated with periods of rising US policy rates. Indeed, the recent decline in equity volatility as measured by the VIX index, leaves the average since the Federal Reserve began raising rates in December 2015 broadly in line with the hiking cycles in the 1990s and 2000s.
What is more unusual is the historically low level of interest rate volatility. The MOVE index – a measure of implied volatility in the US Treasury market – tends to be above its long-run average during hiking cycles (Figure 4). However, it recently fell to an all-time low.
The low level of US fixed income volatility likely reflects a combination of continued quantative easing (QE) outside the US, the gradual pace of rate hikes since December 2015, the strong forward guidance from the Federal Reserve that the pace will continue to be gradual and market scepticism that even the Fed’s expectation of rate hikes will be delivered.
Looking ahead, it is possible that market volatility will remain low. Indeed, we have seen extended periods of low market volatility in the past. Our central expectation for robust global growth and moderate inflation should be consistent with a low volatility regime.
However, it seems clear that the balance of risks is tilted towards increased volatility. The Federal Reserve has recently announced the start of the wind-down of their holdings of US Treasuries and mortgage-backed securities (MBS). We expect the ECB will announce a tapering of their asset purchases later this year, with a likely end to that programme in mid-2018. As central banks step back from these markets it is likely that term premia will increase and volatility could rise.
Moreover, we expect a further gradual withdrawal of monetary stimulus in the US over the coming years, with one more increase in rates this year, and another two or three in 2018. That is well in excess of current market expectations and should it come to pass would likely result in increased volatility.
With global growth surprising to the upside, reduced expectations of rate increases in the US and corporate earnings turning positive in most markets, global equity markets have performed strongly this year (Figure 5), led by emerging markets.
We expect the global backdrop to continue to support equity markets, but are conscious of valuations becoming stretched in some areas. In particular, the positive re-rating of the US equity market has unusually come at the same time as the Federal Reserve has pursued tighter policy. That probably reflects that little of that tightening has flowed through into longerdated yields, and therefore not really tightened financial conditions.
European and emerging market equities no longer look especially cheap, but relative to the US are more attractive in terms of valuation. The recent underperformance of European equities has come at the same time as the euro has strengthened, dampening profitability for those companies with an international footprint. However, we think that there remains scope for European equities to re-rate higher.
Corporate credit spreads have tightened over the course of 2017, with investment grade spreads close to their lowest levels since the beginning of 2008. We remain cautious on the outlook for credit, with the risk that increased volatility could lead to a widening in spreads.
Moreover, the “reach for yield” environment has seen increased issuance of riskier credit, such as covenant-lite bonds and leveraged loans. While these segments of the market do not currently pose a significant risk to the broader credit market, they do increase the vulnerability to future shocks. We continue to favour local currency emerging market (EM) debt over corporate credit, with improving fundamentals and a carry-supportive environment.
Softer inflation outturns through the middle of 2017, particularly in the US, led to a decline in sovereign yields. Ten-year US Treasury yields reached their low for the year in early September, some 40bps down on the start of the year. However, more recent evidence of inflation reaching a local inflection point saw yields pick up to be little changed since our Q3 House View.
As we expect US inflation to move steadily higher and the Fed to continue tightening policy, we see the balance of risk to yields being to the upside. That is supported by our view of gradual reduction in policy support in the Eurozone and other developed market economies moving towards a tightening bias. Indeed the two main policy surprises in recent months were the two rate increases at the Bank of Canada (BoC), and indications from the Bank of England (BoE) that they were closer to raising rates.
In foreign exchange markets, the dominant theme this year has been US dollar weakness (Figure 6). Compared to the US dollar, G10 currencies have returned around 8-15 per cent (with Japanese yen the notable underperformer) while emerging market currencies have returned between 6-25 per cent.
In both instances, these represent the total return for these currencies, including the relative interest rate differential. As such, the weakening in the US dollar cannot be explained by changing relative interest rate differentials. Instead, the move seems to reflect a range of other factors that have raised US risk permia (such as domestic and international political factors), but also factors that have lowered risk premia elsewhere (e.g following the French election, the prospect of further integration in the euro zone and the benign global environment reducing risk premia in emerging markets).
Looking ahead, we take a fairly neutral view on the dollar. We expect interest rate differentials to be supportive, but should the benign global environment persist, that high-yielding currencies will continue to benefit.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at 30 September 2017. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Some of the information within this document is based upon Aviva Investors estimates.
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