House View: Q2 2017
The global economy edges closer to normalisation
After a number of false starts, the global economy appeared to finally find a firmer footing in the second half of 2016. Nearly ten years after the onset of the global financial crisis, the deepest financial and economic crisis since the great depression of the 1930s, the scars left on the global economy may finally be fading. While progress is most clear in the United States, what has been encouraging about developments in recent months has been the synchronized and broad-based nature of the growth upswing. According to Markit PMIs, global manufacturing rose to near its strongest rate in over five years in February, with gains seen across both developed and emerging markets (Figure 1). The rapid improvement in global manufacturing is in stark contrast to the first half of 2016, when many feared global recession. The recovery in manufacturing has also been accompanied by a pick-up in global trade volumes. Trade growth has been slower than global output growth for much of the past five years, a highly unusual situation. However, the most recent indicators suggest that trade growth is likely to rise above output growth in the coming months.
While the manufacturing upturn has been particularly notable, the service sector has also seen gains, albeit they have been somewhat more muted. The rate of improvement has also been starker in survey-based measures than it has in the official or ‘hard’ data. Looking ahead, we will be looking to see the hard data better reflect the survey evidence. If it does, as we expect, it should translate into global GDP growth of around 3.5% in 2017, the fastest rate of growth since 2011. Across the major developed market economies we expect modestly above-trend growth for all but the UK. The rise in global growth has come at the same time as global inflation has risen to multi-year highs (Figure 2). Having risen modestly over the first half of 2016, CPI inflation picked up more rapidly in the major developed economies in recent months. That pickup reflects a stabilisation and subsequent increase in commodity prices during 2016. That saw the contribution to inflation from energy and food move from deeply negative to modestly positive. Core inflation, which removes energy and food price inflation, has risen moderately in the US, but has been low and stable in the euro zone and Japan. With above-trend growth expected in the major economies this year, spare capacity will continue to be eliminated, which should put upward pressure on wage growth and core inflation.
Fundamentals to once again drive markets
The post-crisis road to economic ‘normalisation’ has been a long one, and downside risks certainly remain. However, we think more than at any time in recent years the global economy is likely entering a sustained period of solid growth and moderate inflation. In part that reflects the healing of private sector balance sheets over recent years. But importantly we also expect that policy support will remain in place for some time. Monetary policy remains loose in all major economies, with the European Central Bank (ECB) and Bank of Japan (BoJ) expected to continue with Quantitative Easing (QE) policies throughout 2017. That will see the balance sheets of those central banks continue to grow, boosting global liquidity (Figure 3). With global policy rates also expected to remain low – only the Federal Reserve are expected to raise rates gradually this year – short-term real interest rates are set to remain negative. Alongside the monetary support, there has also been an increasing willingness to use fiscal policy. Perhaps most significantly, the fiscal boost in China during 2016 is expected to be maintained in 2017. It should continue to provide a material amount of support to Chinese growth, which in turn is supporting global commodity prices, manufacturing and trade. While the details of the anticipated tax and spending plan from the Trump administration are still to be revealed, we expect a package of tax cuts will be passed towards the end of this year. That will provide a further boost to US growth, albeit at a time when it is perhaps not entirely warranted. Nevertheless, it should also have positive spill-over effects to the rest of the world.
Global markets have responded to recent economic and political developments, with risk assets performing particularly well year-to-date. Looking back over the past nine months, a period over which we have expected that the world was moving into a more reflationary environment, global equity returns have been strong, led by Europe and Japan (Figure 4). Earnings growth in 2016 Q4 was the strongest in two years for developed market equities, and forward estimates have been revised higher. From a valuation perspective, Europe remains more attractive relative to the US, but the political risks in France and Italy may keep investors on the sidelines. In emerging markets, the pickup in global growth and inflation has provided an attractive backdrop for equity markets. Combined with the large valuation discount compared to developed markets, we expect emerging market equities to continue to outperform, but remain cognisant of the risks, in particular the sustainability of the Chinese credit boom. Global credit markets have also performed strongly over the past nine months, especially high yield markets. That has reflected a sharp improvement in performance by financials and other cyclicals. In the US credit spreads probably price too little risk now, and therefore risk widening even with a positive growth backdrop. In Europe, the impact of ECB and Bank of England (BoE) purchases has left little upside on valuations.
At the other end of the returns spectrum, the reflationary environment has been negative for risk-free assets, with a negative return on government bonds of the major economies over the period. Those relative asset class moves represent a stark change from recent years, when both risk-free and assets have generally moved together. The rise in US government bond yields has reflected an increase in both real rates and market-based expectations of inflation. That increase in term premia (both real and inflation) has permeated across most of the world (Figure 5). While we expect bond yields in developed markets to move higher, supported by a stronger global economy and a gradual turn in monetary policy, there will likely need to be a new catalyst in the near-term to see yields move beyond what is priced into forward rate markets. That catalyst may be the Trump administration providing more clarity on the expected tax cuts. Or it could be a move higher in commodity prices driven by changes in either demand or supply conditions. But risks also lie in the other direction, most notably the increasing nationalist political agenda around the world and the potential for protectionist policies leading to a full-blown trade war. In emerging markets, the same risks dominate, however, the fundamental backdrop continues to be supportive. We think that the local currency debt markets are likely to outperform hard currency, with long-term valuations far more attractive in the former.
Following the strong performance of the dollar after the US election, where it rose against all major currencies, this year has seen somewhat of a reversal (Figure 6). In particular, high yielding emerging market currencies have outperformed on the improvement in global growth and decline in broader market volatility. With the hopes of an early and large US fiscal stimulus waning, alongside a number of early mis-steps by the Trump administration, the support for the dollar has eased. That was despite an earlier than expected rate hike from Federal Reserve. With two more Fed hikes this year largely discounted in the market, the scope for further near-term dollar strength will likely depend on developments in other markets.
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