As a result, both the futures markets and the forecasting community think that a Fed move is not imminent (the Fed next meets on Sept. 20). The FedWatch indicator based on the Chicago Mercantile Exchange’s futures prices currently puts an 85% probability on no change at the September meeting and a 78% probability of no change at the November meeting, but the odds are roughly 50/50 for an increase in December. Similarly, nearly three quarters of the economists in The Wall Street Journal’s monthly poll from September believe the first increase will be in December.

The reaction of the bond markets may have been somewhat premature, but it serves as an important reminder of the underlying risks to fixed interest. U.S. inflation is likely to rise at some point, with The Wall Street Journal‘s forecasting panel expecting inflation to run at a little over 2% in both 2017 and 2018; U.S. monetary policy will eventually be normalised, however slow and gradual that process may turn out to be. Eventually, U.S. bond yields will need to rise from their current levels, which do not compensate for the likely rate of inflation and have only made sense while inflation has been unusually low. The Wall Street Journal panel reckons that the U.S. Treasury bond yield will need to rise to 2.3% by the end of next year and to 2.7% by the end of 2018.

These expected rises are not dramatic, and the bulk of rises in global bond yields are likely to be quarantined to the United States. Central banks in the eurozone and Japan will still be struggling with inflation that is too low and economies that are too sluggish, while the Bank of England may also need to keep monetary policy very supportive as the actual movement of Brexit draws closer. Inflation everywhere has turned out lower than forecasters had anticipated. And rises in bond yields could also be delayed by new episodes of nervousness in the equity markets, which could trigger further safe-haven bouts of bond-buying. All these factors suggest that overall global bond yields will rise only modestly over the next year, but even so, fixed-interest-rate investors are facing more difficult times ahead.

International Equity - Outlook

As noted earlier in the International Fixed Interest section, investors in recent weeks have become more concerned about the prospect of higher interest rates (principally in the U.S.), and their concerns have spilled over into global equity markets. Investors have been questioning the ability of the U.S. economy (which has been one of the ongoing engines of global growth) to cope with less supportive monetary policy, and they have also had to confront the potential for tighter monetary policy to upset the relative valuations of bonds and equities. Ultralow interest rates have been one element in driving equity valuations up to expensive levels by historical standards.

For the time being, immediate Fed policy tightening looks less likely. One factor has been the latest set of U.S. jobs statistics. The numbers were not terrible (151,000 new jobs in August, which was inside the forecast range of 125,000 to 215,000, although a bit lower than the consensus pick of 175,000), but they were a slowdown from the pace of net hiring in previous months. While the ordinary, rather than strong, jobs numbers were helpful in that they may have held back the Fed’s tightening hand, from another perspective, they signalled that the underlying performance of the U.S. economy—and the ability of corporates to generate the profits that would support expensive share valuations—may be ebbing.

The same picture of a still-growing (albeit more slowly) American economy came through in August’s Institute of Supply Management indexes, which were on the weak side. The manufacturing index actually fell below 50, suggesting that manufacturing output may have dropped, with 11 of the 18 manufacturing sectors reporting lower output and only six still growing. The nonmanufacturing sectors of the economy were still expanding, but not as fast as in July, and there was a particularly sharp drop in the amount of new orders being taken in, which does not bode well for future production. On a more “glass-half full” view, ongoing (if slower) growth in the nonmanufacturing parts of the U.S. economy has made up for the setback to manufacturing, and the overall economy is still growing: August marked the 85th month in a row of growing activity.

It is much the same story for the wider global economy. The August reading from the J.P. Morgan Global All Industry Output Index was still showing ongoing world economic growth, but at a slower rate than before. J.P. Morgan commented: “Further highlighting the generally subdued performance of the global economy during the year to date, the highest index reading so far in 2016 was below the lowest figure registered during the whole of 2015.” Japan and Brazil in particular held back the overall performance. Similarly, employment was still growing, continuing a six-and-a-half year winning streak, but again more slowly than previously as “the rate of increase was the weakest since April 2013.”

Equity investors have not liked the look of the global economy growing quite slowly (and arguably slowing down a bit further in recent months) set against high equity valuations and the prospect that the precarious equilibrium of both expensive bonds and expensive equities will break down if bond yields start to rise. The potential for further setbacks along September’s lines remains quite high. As September’s survey by Bank of America Merrill Lynch showed, fund managers think equities are very expensive (the most expensive since 2000); they are particularly worried about the impact of further rises in U.S. bond yields and are concerned about too many investors, all trying to avoid unusually low bond yields, have crowded into the same bets (such as emerging markets); and they are holding historically high levels of cash because of their unease.

The world economy will push through the current spot of cyclical weakness. Forecasters (as surveyed in The Economist’s September international poll) are still predicting that the developed economies will post some growth next year. However, the anticipated growth rates are modest: 2.0% in the U.S., 1.2% in the eurozone, and even less in Japan (0.8%) and post-Brexit Britain (0.5%). Emerging markets will do rather better—both Brazil and Russia will emerge from recession, while China and India will continue to register rapid growth. But overall, it is likely to be a picture of slower-than-usual growth in world business activity, with the potential for flurries of concern over growth prospects. In these circumstances, particularly when it becomes clear that U.S. interest rates are definitively increasing, we are likely to see repeats of this month’s rethink of the expensive value on offer from global equities.

Performance periods unless otherwise stated generally refer to periods ended 13－14, September 2016.

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