Elsewhere in the developed world, particularly in the eurozone and Japan, inflation generally remains well below where central banks would like it to be, and economic activity is sluggish. Japan, the major economy with the greatest inflation challenge, is still struggling with it. The latest inflation data (for June) showed that the headline rate of annual inflation was still negative 0.4% and the “core” rate, which excludes volatile food prices and which is the rate being targeted by the Bank of Japan, was a little lower again (negative 0.5%), markedly adrift of the Bank of Japan’s 2% target. Eurozone inflation has also been very low (only 0.2% in the year to August). The European and Japanese central banks will be sticking with very supportive monetary policy, including a programme of bond buying which depresses bond yields.

In the U.K. inflation is expected to be higher—the Bank of England is forecasting close to 2.0% by the end of next year, boosted by the sharp fall in the British pound—but again the central bank will not be raising rates anytime soon. Forecasters expect the bank will have its hands full managing post-Brexit shocks to the U.K. economy, and the financial markets’ latest assessment is that the key“bank rate” will still be close to zero in two years’ time.

Bond investors consequently will be in an awkward position. Bonds still provide insurance against the likes of Brexit shocks. But yields have effectively fallen as far as they can go, which means the large capital gains of recent years are nearing their end, and that portfolio income is likely to be below desired levels. Efforts to restore preferred income yields by venturing into riskier regions or sectors come with their own dangers: it is not obvious that accepting 2% to take Russian credit risk or 2.75% to take Bulgarian risk is a bet that is sure to work out well. Bond valuations, in summary, are highly expensive, and while this may not matter as long as inflation remains unusually low and world economic activity is somewhat subpar, there is still a lurking longer term risk of a return to more normal market conditions, with attendant capital losses.

International Equity - Outlook

The recent performance of world equities, with the U.S. the pick of the developed economies and strong price rises in some of the emerging markets, aligns strongly with the most recent assessments of the global economic
outlook.

The International Monetary Fund, or IMF, in the latest (July) update of its World Economic Outlook, expects the world economy will grow by 3.1% this year and pick up a little to 3.4% growth next year. However, the pattern is uneven with the developed economies expected to grow by only 1.8%, with the U.S. doing better (2.2% growth this year) than either the eurozone (1.6%) or Japan (0.3%), while the emerging economies are expected to grow quite strongly (4.1% this year, 4.6% next).

A Reuters poll of 500 economists around the world, taken in late July, came to the same conclusions. The economists expect ongoing global growth at a rate very similar to the IMF’s take, with next year a tad better than this year’s performance, and again with a pronounced split between slower-growing developed economies and faster growing emerging markets, particularly India, China and Indonesia. Brazil and Russia are predicted to turn from recessions this year to a return to economic growth next year, which helps explain the recent surges in their stock markets. Argentina is also expected to emerge strongly from recession next year.

Given that world share markets are on generally expensive valuations, equity markets will need ongoing regular evidence that this reasonably sanguine outlook for global economic activity is indeed coming to hand. So far, the omens are mostly good. In the U.S., for example, forecasters had been cautious after a strong (287,000) rise in jobs in June, and had expected July’s jobs growth to ease off to a still respectable 185,000. In the event, July also saw a big rise of 255,000, well above even the most optimistic forecaster’s advance pick (215,000). The participation rate also increased, which was a welcome sign jobseekers are feeling good enough about the availability of jobs to re-enter the labour force.

It is unlikely, however, that the flow of economic and political news is going to be systematically positive, and the likelihood is that expensive share markets will, from time to time, have further episodes along the lines of January/February of this year. While equities will continue to benefit from their relative valuation advantage over zero short-term interest rates and very low bond yields, they are currently on valuations that leave little room for things to go wrong. On Standard and Poor’s calculations, for example, the S&P500 is trading at 17.3 times next year’s corporate earnings.

Another way to see the currently high level of expectations is in the pricing of the VIX index, which measures the volatility investors expect to encounter from holding the S&P500 index and which is now at very low levels. It had spiked in January and February (on fears of a slowdown in global business activity), dropped back in subsequent months, jumped again in June (Brexit), and once more dropped back in recent weeks, to its lowest levels of the year. Investors are currently over-relaxed about the risks to the global economy. They are not completely complacent—shares which fail to meet expectations are getting hammered—but an additional element feeding into unusually high valuations is an underappreciation of the potential for adverse surprises.

The liquidity from ultra-easy monetary policy, the resulting unattractive pricing of cash and fixed interest, and ongoing global growth still provide some solid underlying support for equity performance. But current prices are not an adequate reflection of true levels of economic and political risk.

Performance periods unless otherwise stated generally refer to periods ended 12 August 2016.

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