Deal or no deal?
Ian Pizer says the prospects for the global economy and risk assets are encouraging.
- Rebounding US output underpins favourable outlook for global growth
- It is unclear how much events in Greece will affect the world economy
- A US rate rise is justified, though unexpectedly fierce hikes could hit confidence and markets
- Prospects for risk assets look encouraging, though government bond yields remain unattractive
We believe the world economic outlook remains broadly favourable with global output set to expand at close to its trend pace this year and next. The US economy has rebounded reasonably strongly following an unexpectedly sharp slowdown in the first quarter, while there are signs of improvement in Europe and Japan too.
However, it is unclear how events in Greece will affect the global economy. Our central case is that aggressive action by European authorities will minimize the impact. Having said that, there are material downside risks in the event this is not the case.
Developed economies lead the way
The US central bank looks poised to raise rates for the first time in more than nine years in response to the recent pick-up in domestic economic data. The downturn seen at the start of the year looks to have been either temporary or a statistical blip. Certainly, there have been plenty of other signals that suggest the US economy is in better shape. In particular, two areas that the Federal Reserve (Fed) deems especially important – the jobs market and monetary trends – have painted a markedly more upbeat picture.
European economic data has also strengthened steadily in recent months, after the European Central Bank (ECB)’s belated introduction of ‘quantitative easing’ helped underpin confidence. The ECB’s action, by weakening the euro, has provided a boost to the region’s exporters.
The world is learning to deal with a new norm: a slowing Chinese economy. While output this year is likely to increase by around seven per cent, this would be the slowest rate of growth seen since 1990. But this deceleration is an evolutionary process and not a cause for major concern.
US rate risks
We believe the Fed is right to consider raising interest rates. It may well be that not much tightening of policy is required. But not moving soon would, in our view, be a mistake. While there is a risk that longer term market interest rates in the US could rise significantly, both the domestic economy and riskier asset classes should be able to withstand this. After all, the rise in rates is being driven by firmer economic data.
That said, we cannot rule out the possibility that a sudden surge in rates, augmented by reduced liquidity in US fixed income markets, could hit investor confidence sufficiently to negatively affect risk assets. That could potentially have detrimental effects on global activity. We view such an event as unlikely unless the Fed is pressed into tightening policy more aggressively by a sharper rise in US inflation than is currently anticipated.
Such an event would clearly have a negative impact on emerging nations as capital outflows could drive asset prices lower and currencies weaker against the dollar. Few emerging economies would be immune, although China, India and Russia have historically shown markedly less sensitivity to developments in US financial markets than other emerging economies.
The outlook for riskier assets in general, and shares in particular, remains moderately favourable. But given that many equity markets still close to record highs, shares are no longer cheap, particularly since it appears they will soon have to contend with higher US interest rates.
We favour Japanese and European shares. Both will continue to be supported by the actions of the Bank of Japan and ECB. US stocks look relatively more expensive given the outlook for US interest rates and the strength of the dollar. Emerging market equities also continue to look vulnerable given the likelihood the dollar will continue to appreciate.
We believe prospects for corporate bonds are mildly positive. Although the ongoing hunt for additional returns has pushed yields, relative to those available from government bonds, to their lowest level for some time, companies’ balance sheets are generally in healthy shape.
As for government bonds, yields remain unattractive despite the recent sell-off.
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