Executive summary: Fed up - but the mood is improving
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Global growth set to be strongest since 2011
Over the course of 2016 H2 global growth accelerated, led by a broad-based recovery in industrial production. Policy support in China saw increased demand for raw materials, pushing up commodity prices, while the stabilisation in oil prices saw production recover in the United States (US). At the same time the Eurozone recovery picked up pace, encouragingly driven by domestic demand. The broadbased move saw growth for the G20 economies rise to over 3¼ per cent in Q4 (compared to a year ago). The improvement in global growth was followed by an even sharper pickup in global trade, with growth in imports in the year to 2017 Q1 rising at the fastest pace since 2011 (Figure 1).
The pace of output and trade growth likely eased somewhat in Q1, with both China and the US slowing. We expect growth to rebound in the US in Q2, while China is expected to achieve their annual target of around 6.5 per cent this year. Most other major economies saw steady or improved growth in Q1, with the United Kingdom (UK) the major exception. Looking ahead, we continue to expect global growth of around 3.5 per cent this year, the fastest rate of increase since 2011. As ever, there are risks to that outlook. On the downside, the policy support in China may be withdrawn more quickly, weighing both on Chinese growth and emerging market economies more generally. On the upside, the recovery in the Eurozone may accelerate more rapidly, with survey evidence pointing to faster growth over the coming months. Overall we expect to see modestly above trend growth in the major economies (except the UK) this year and think the near-term global growth risks are broadly balanced.
Outlook is for moderate inflation, with core rising steadily over the coming years
At the same time that global growth accelerated, measures of inflation also began rising (Figure 2). The rapid increase in CPI inflation reflected a stabilisation and subsequent increase in commodity prices during 2016. Core inflation remained low and stable in most major economies, with only the US seeing a steady move higher, albeit to a level still below the Federal Reserve’s target. In recent months inflation has stabilised, and in some instances fallen back a little, again reflecting developments in commodity prices alongside stable core inflation. The decline in core inflation in the US has largely reflected a number of temporary factors and should reverse in mid-2018. That said, headline rates of inflation globally are expected to move steadily lower over the coming months as they converge on the somewhat lower rate of core inflation. While the risks of deflation remain much lower than in 2015/16, the risk of a rapid move higher in inflation from here also seems remote. We expect that with above-trend growth in the major economies this year, spare capacity will continue to be steadily eliminated, which should put modest upward pressure on wage growth and core inflation. We expect the US to be more advanced in that process than others, and as such expect the Federal Reserve to continue raising rates, once more in 2017 and three more times in 2018.
Investors doubt global reflation
In the middle of 2016 the median forecast for near-term global growth was subdued. When growth began to accelerate in the second half, the market was taken by surprise. The Citigroup measure of data surprises showed that by early 2017 the positive growth surprises in both developed and emerging market economies were larger than at any time since 2010. At the same time, the positive surprise on inflation was even starker, reaching levels not seen since the oil price shock of 2008. The positive data surprises, alongside expectations of improved future growth and inflation (which were also at least partly driven by expectations of a boost to US and global growth from the policies proposed by President Trump) saw equity markets rally and fixed income sell off. However, as we progressed through the first half of 2017, with forecasts factoring in stronger growth and inflation, they have surprised to the downside. That has been most pronounced in the US (Figure 3).
Yields on government bonds have declined in 2017, despite Fed rate hikes
The weaker than expected activity and inflation outturns have seen longer-term yields retrace (Figure 4), with lower breakeven inflation rates the main contributor. According to data compiled by JP Morgan, flows into bond funds are outpacing last year, and speculative long positions in US Treasuries are at all-time highs. That is despite a second hike in interest rates this year from the Fed, who raised the policy corridor to 1 -1.25 per cent in June, and indicated that they expect to raise rates once more in 2017 and three times in 2018. At the end of June the market had little more than one hike priced over the next three years. Alongside a continuation of rate hikes, the Fed have also indicated they will begin to slowly unwind their holdings of Treasuries and mortgage-backed securities later this year. We expect the benign global environment will continue to be supportive for government bonds, but see the risks tilted to the downside.
Global equity markets have performed strongly, with earnings expectations rising
While the bond market has largely unwound much of the initial response to the global reflation theme that developed last year, global equity markets have reached new highs. Indeed, risk assets have performed strongly year-to-date, with emerging market equities leading the way, but closely followed by US and European equities (Figure 5). The rise in equity prices reflect both improved earnings growth, with double-digit year-over-year gains in all major developed markets in Q1, and a positive re-rating. The latter is particularly unusual in a midst of a rate hiking cycle as we have in the US. We think that reflects the excess liquidity in financial markets from previous and current rounds of Quantitative Easing (QE) by central banks and the collapse in both implied and realised market volatility. European equities rerated on the positive outcome of the French presidential election, but remain more attractive than the US on valuation basis. We also continue to favour emerging market equities on positive earnings outlook and relatively favourable valuation.
Credit markets have performed strongly on improved fundamentals and technicals
Global credit markets have also performed strongly over the past six months. That has reflected an improvement in fundamentals, but also more favourable technical, owing to strong demand from yield-sensitive buyers. With the further narrowing in spreads, credit has become relatively less attractive, with emerging market (EM) debt offering better opportunities. We expect local currency EM debt to continue to benefit from improving fundamentals and carry-supportive environment.
Following the strong performance of the dollar after the US election, this year has seen a reversal, with both EM and G10 currencies rising against the dollar (Figure 6). The most notable performer in recent months has been the euro, which was boosted by positive election outcomes in the Netherlands and France. While the US is the strongest economy, and the Fed is pushing ahead with rate hikes, the decline in the dollar likely reflects a combination of disappointment with the lack of delivery from the Trump administration and positive surprises elsewhere. We expect the dollar to be fairly range-bound in the near-term, with potential for the euro to move modestly higher, but the yen to weaken. We expect positive carry emerging market currencies to continue to perform well in a low volatility environment.
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