Global Economic Update (2016/NOV)

The global economy has been showing some signs of a modest pickup in activity

Morningstar Analysts 25 November, 2016 | 11:55
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Outlook for Investment Markets

The shock victory of Donald Trump in the U.S. presidential election is still working its way through the financial markets. One important impact has been immediately higher bond yields, which has led not only to capital losses for bonds but also losses for “bond surrogate” assets such as property and infrastructure. Equities have been less affected, principally because of an expected fiscal boost to the U.S. economy. The fuller implications of the Trump presidency will take some time to become apparent. In the meantime, the global economy has been showing some signs of a modest pickup in activity.

International Fixed Interest — Outlook

While the outlook remains uncertain—at the time of writing, we do not even know, for example, who will be nominated to the top economic policy roles in the new Trump administration—analysts have been focusing, in on two issues in the U.S.

One is the consequences for the operation of monetary policy. During the election campaign, the Trump camp disparaged the current regime of ultra-low interest rates, and expressed a desire for more normal monetary policy. Over time, as the current Fed policymakers’ contracts fall in, they may well be replaced by people more inclined to raise interest rates more rapidly.

The other is the consequence for interest rates of a Trump administration running a more expansionary fiscal policy. Currently, the financial futures market believes there is only one small increase in the federal-funds rate on the immediate horizon. According to the Chicago Mercantile Exchange’s FedWatch tool, there is a 90% probability of a 0.25% increase at the Fed’s meeting on Dec. 14. After that, the FedWatch calculations are pointing to no further increase until mid-2017 at the earliest, and even then, there is only a 35% chance of another 0.25% increase. This looks a rather low-ball estimate of what might be needed in an economy that could be reflecting the unemployment and inflation effects of easier fiscal policy (from tax cuts and from increased public spending).

In current circumstances, trying to estimate these potential impacts is a tall order, but the general direction is clear: interest rates in the U.S. look likely to rise earlier and rise faster than seemed probable before the election. The first sighting shot we have seen on the post-election outlook has come from the November Wall Street Journal poll of U.S. forecasters, which providentially was run just after the election. It showed forecasters expect inflation to run a little above the Fed’s 2% target level throughout 2017 and 2018, and they have raised their expectations for bond yields. In the previous month’s poll, they had predicted a 10-year Treasury yield of 2.3% for end 2017 and of 2.7% for end 2018. Those have since been raised to 2.5% and 3.0%.

Bond yields had been unusually low even before Trump’s election, as government and treasurers realised. They filled their boots while the going was good, with the latest statistics from U.S. data company Dealogic showing 2016 may well have seen the all-time-record for bond issuance. There has been over USD 6 trillion year-to-date, which threatens to beat 2006’s full-year record of USD 6.6 trillion.

The treasurers recognised that some normalisation—certainly in the U.S., less so in the eurozone and Japan—was always inevitable. The normalisation now looks to be under way, and will likely create difficulties in coming months both in the bond markets, where yields had been driven too low for the inherent risks, and in other markets exposed to higher bond yields (notably property, and equity market “bond surrogates,” such as utilities).

International Equities — Outlook

The markets’ attention has been heavily focused on what the new Trump administration will aim to do. At the time of writing, there was only the campaign record to go on, as new appointees had not been named to the incoming executive, and one major uncertainty was the degree to which campaign rhetoric might or might not translate into policy reality. Another uncertainty was how the different agendas of the Republican-controlled Senate, House of Representatives and White House might or might not be reconciled.

Analysts’ early conclusions were that the Trump administration would be likely to provide a sizeable fiscal stimulus to the U.S. economy, with both tax cuts and increased government expenditure (particularly on infrastructure) likely to be in play. Deregulatory initiatives might also boost some sectors: bank and energy shares rallied on expectations of regulatory rollback. The short term outlook for business activity in the U.S. consequently looked likely to be stronger than anticipated pre-election.

The longer-term outlook, however, may have deteriorated. Fiscal stimulus will add (potentially substantially) to the level of U.S. government debt. Antitrade and anti-immigration policies could reduce the long-term growth rate of the U.S. economy (as well as that of the world economy). As well, the risk of geopolitical setbacks may well have risen. While there could be better relations with some countries (with, for example, Russia over the war in Syria), the tone of the Trump campaign on foreign policy was generally confrontational.

At this point, forecasters are only beginning to revise the immediate outlook for the U.S. economy. The November Wall Street Journal poll of American forecasters, taken immediately after the election, showed forecasters had not yet made any change to their expectations for GDP growth in 2017, which remained at 2.2%, but had raised their expectations for 2018 from 2.0% to 2.3%. The likelihood is that there will be more revisions upwards in coming months. The exact numbers may be secondary: the more important takeaway is that forecasters have changed their view from an expected slowdown to an expected acceleration in the U.S. in 2018. The recent rise in U.S. equities may well be accurately signalling a turn for the better in the near-term outlook for American corporate profitability.

With politics dominating the news, the economic fundamentals have been something of a sideshow, but both in the U.S. and globally, they too have been providing some indication of stronger support for corporate performance.

In the U.S., the new jobs numbers have been solid (191,000 in September, 161,000 in October), and wage growth has been accelerating with the 0.4% rise in October well above forecasters’ expectations. Better pay-packets seem to be working their magic on consumer confidence: it appeared to have wobbled in October (on the University of Michigan’s index), but recovered in November. The survey was taken before the election result, so it remains to be seen how it has fared since, but is seems to be translating into a spend-up in the shops. Retail sales have been impressive, rising by a very strong 1.0% in September and by a further 0.8% in October. Overall, the U.S. economy was travelling reasonably well even before the likelihood of more stimulatory fiscal policy.

Global economic activity has also been strengthening to some modest degree. The various surveys compiled by Markit show a consistent picture of a pickup in performance. By industry, for example, every single one of the 23 sectors covered in Markit’s latest (October) Global Sector Purchasing Managers’ Index was growing, with Markit commenting: “The global economy witnessed a broad-based acceleration in growth by industry in October, led by the technology sector.”

Markit’s regional surveys showed the same improvement. In Europe: “The rate of eurozone economic expansion gathered pace at the start of the fourth quarter. Output rose at the quickest pace since January,” and in China the data “indicated the fastest expansion in Chinese business activity since early 2013.” Japan was also a bit better than before: “the overall Nikkei Composite Output Index posted above the 50.0 no-change mark for the first time in three months (51.3). Moreover, the latest reading was the sharpest since January.” Overall, at global level, as measured by the JP Morgan Global Manufacturing and Services PMI: “The start of the fourth quarter saw a solid improvement in the rate of global economic expansion. Output rose at the quickest pace in almost a year, driven by the sharpest growth in new orders over the same period.”

On the plus side, in summary, the near-term economic fundamentals appear to have improved for international equities. On the minus side, even allowing for modestly better profit prospects, valuations remain expensive by historical standards, and if bond yields continue to rise, overvalued equities could come under pressure on relative valuation comparisons. Emerging markets look riskier than before, mainly because of likely increased barriers to trade. Global equities, for now, look like a cautious “hold,” though any stronger conclusion will await greater clarity from Washington on the new administration’s intentions.

 

 

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