Global Economic Update (2016/JUN)

Further episodes look likely during the year as investors periodically reassess the downside risks to global business activity.

Morningstar Analysts 20 June, 2016 | 15:28
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Outlook for Investment Market

World equity markets have had another episode of nervousness, partly linked to the UK's Brexit referendum and partly to some evidence that global economic growth, while continuing, is slower than previously expected. Further episodes look likely during the year as investors periodically reassess the downside risks to global business activity. On the positive side, assets seen as defensive (property, infrastructure, government bonds, gold, the yen) have been beneficiaries of heightened investor concerns.

International Fixed Interest - Outlook

There are three factors that will determine the outlook for fixed-interest performance. The most important is what happens to US monetary policy. Other economies have their own issues, but the impact of US interest rates tends to be ubiquitous, directly or indirectly. As expected, the US Fed left monetary policy unchanged at its June meeting, but there is still the possibility that it might raise rates later in the year. The Chicago Mercantile Exchange's "FedWatch" indicator, which calculates the financial futures market's implicit probability of Fed moves, currently indicates that the Fed, at most, will raise rates only once this year: there is a roughly 50-50 chance of an increase at its December meeting. To the extent that other bond markets mirror US developments, bond yields are likely to remain low given that the Fed's tightening (if any) will be slow and modest.


The second issue is the outlook for inflation. Nobody is entirely sure why inflation has remained as low as it has, despite monetary policy aimed at getting it back to more normal levels (around the 2% mark for both the Fed and the European Central Bank). In the eurozone, for example, prices in May were actually lower (by 0.1%) than a year ago; even allowing for lower petrol prices, the latest inflation rate of 0.8% was well adrift of the ECB's target. Other economies are also struggling to shift inflation higher: In Japan, for example, prices are unlikely to rise this year (according to The Economist's latest survey of international forecasters), despite one of the world's most aggressively stimulatory monetary policies. Again, this suggests that there may be an extended period of low bond yields.


The third factor is safe-haven buying of government bonds. As discussed elsewhere, the global economic outlook, while moderately positive, could be derailed by unanticipated setbacks, which would increase investor anxiety, stimulate greater demand for low-risk assets, and further depress government bond yields. Corporate bonds, however, could be a casualty if the economic outlook darkened significantly.


Most of the likely developments tend to suggest that current ultralow government bond yields have a good chance of persisting in coming months and that bonds have a fighting chance of replicating this year's highly effective insurance of portfolio performance. How far this argument can be pushed remains highly problematic, however: These are very unusual times, and from a longer-term perspective investors may well ask how likely is it that benchmark bonds in important markets can continue to see lenders paying borrowers.

International Equity - Outlook

The outlook for international equities remains much as it has been all year–shares have the benefit of ongoing global economic growth, but they are expensively priced for the growth that looks likely and are prone to sell-offs when any of a number of potential downside risks to global growth looks like materialising, as Brexit has in recent days. It has not helped that the latest forecasts for world growth from the World Bank have downgraded the likely pace of global growth. Its latest (June) update of its Global Economic Prospects still has the world economy growing by 2.4% this year and by 2.8% next year, but these numbers are lower than the World Bank's previous set of forecasts in January (lower by 0.5% for this year and by 0.3% for the next). They do not leave much slippage room for things to go wrong, especially in the developed economies, which the World Bank reckons will grow by only 1.7% this year, although growth in emerging markets will be rather stronger (the World Bank is forecasting 3.5%).

Somewhat more sombre expectations were reinforced by the latest US jobs numbers, which once again have proved to be one of the key influences on global financial markets. There was an unexpectedly poor outcome in May, when there were only 38,000 new jobs. This was well below the roughly 160,000 jobs forecasters had been expecting (having allowed for a strike at telco Verizon, which temporarily took 35,000 jobs off the numbers). While the unemployment rate dropped to 4.7%, this was also more a sign of weakness than strength, as it reflected discouraged people withdrawing from the labour force and not being counted by the statisticians as unemployed.


Global business surveys confirm the mediocre growth in economic activity. As Markit commented on the latest (May) JPMorgan Global Manufacturing and Services Purchasing Managers Index, “The global economy remained in a low growth gear in May, continuing its generally weak start to the year. A slower expansion was seen at service providers, while manufacturing production broadly stagnated. Both sectors again reported lack lustre trends in new orders. Market conditions will need to stage a noticeable improvement if growth of global GDP is to break out of its current slow steady pace.”


The modest outlook is also beset with what the World Bank called “pronounced downside risks.” Its short list of immediate issues included further slowdown in major emerging markets (especially among commodity exporters), rising policy uncertainty (the bank mentioned Brexit but could also have added Trump), persistent geopolitical risks, financial market fragility, stagnation in the advanced economies (Japan and the eurozone in particular), and increasing protectionism. It could only think of one potential upside (the benefit to consumers from lower oil prices).


In the circumstances, it is not surprising that investors have been prone to intermittent loss of confidence. Credit Suisse's global Risk Appetite Index, for example, has been in pessimistic mode since the middle of last year (with an outright "panic" reading around the turn of the year). The VIX Index, a measure of the volatility investors expect to encounter in the US share market, has jumped in June as the Brexit vote has loomed. It is not up to the alarm levels of January and early February, but it is well above 'plain sailing' readings. Rising levels of investor apprehension have also been evident in the rising price of gold, the demand for government bonds, and, oddly, the appreciating yen, which apparently has also become a safe-haven option despite the weakness of the Japanese economy.


As for Brexit itself, at the time of writing the outcome was very uncertain. The Telegraph newspaper in the UK runs a poll-of-polls survey that averages the last six polls excluding don't knows: the latest reading had Leave at 51% and Remain at 49%. But there is a large number of don't knows–around 15%–and how they eventually vote (if they do) clearly has the potential to determine the result. For people who believe the best adage is "'follow the money," the Telegraph reports that the latest odds from bookmaker PaddyPower are 8-15 on a Remain vote and 6-4 on a Leave vote (that is, Remain is still the most likely option). Brexit is a good example of the risks that could derail global equities.


On the other hand, investors need to ask whether any individual risk is a how-stopper: will it derail the consensus view of ongoing but modest global growth? A good example is the recurrent issue of whether Chinese growth will disappoint. People may be paying too much attention to small unanticipated changes in Chinese data, which does not make a lot of sense, given that Chinese data are of debatable quality. The bigger picture on latest (May) data is of retail sales running at 10% up on a year earlier, industrial production up 6%, and fixed asset investment by close to 10%. This is remarkably strong growth: Markets may well worry that it does not match previous expectations, but the more important conclusion is that a very large economy will continue to grow at a rapid rate.


In current circumstances, where uncertainty is high, it is hard to say that there is a clear-cut outlook for world equities. The most likely scenario is that the world economy will continue to grow and that profit performance will improve, helping to sustain currently expensive valuations. But the likelihood that this scenario will unfold has dropped in recent weeks.

 

Performance periods unless otherwise stated generally refer to periods ended 14 June 2016.

 

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