Global Economic Update (2016/DEC)

Income oriented asset classes have been badly hit as short- and long-term interest rates have risen, and there is likely more pain to come

Morningstar Analysts 23 December, 2016 | 0:13
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Outlook for Investment Markets

Global financial markets have been focused on the implications of the Trump administration and, more recently, on the impact of the Fed’s decision to start going further down the path to more normal interest rates. On balance, equities have benefitted, as investors have looked to somewhat improved global growth prospects, mostly down to likely faster growth in the United States. Income oriented asset classes, however, have been badly hit as short- and long-term interest rates have risen, and there is likely more pain to come.

International Fixed Interest — Outlook

The Fed’s increase was widely expected, as interest rates clearly no longer needed to be as low as they have been. On the Fed’s latest forecasts, the U.S. economy is likely to be growing at only a modest rate (2.1% next year), but this will be enough to keep the unemployment rate acceptably low (at 4.5%) and for inflation to get back to where the Fed wants it to be (a 1.9% inflation rate for personal consumer spending).

The Fed signalled that it is currently minded to raise interest rates three more times next year, which would bring the Fed-funds target range up to 1.25% to 1.50%. The immediate reaction of market analysts was that the Fed had overestimated the likely extent of rate increases this year and might still be on the high side for potential rises next year, but either way the period of near-zero short-term interest rates in the U.S. looks well and truly at an end.

Higher short-term rates, the prospect of ongoing U.S. economic growth and easier fiscal policy, and, especially, the likelihood that U.S. inflation will be running at around a 2% rate over the next few years have already combined to lead to a strong rise in U.S. bond yields, and further rises look likely: A 10-year Treasury yield of 2.6% does not look sustainable if inflation does indeed average 2.0%. Forecasters’ expectations for U.S. bond yields are consequently being revised: In November, The Wall Street Journal’s panel of U.S. forecasters had been picking that the 10-year U.S. yield would be 2.5%, but this month the consensus estimate has been hiked to 2.8%, and further revisions upwards are to be expected in coming months.

The outlook for international bond returns will remain challenging, although the extent of bond price weakness will be limited by ongoing easy monetary policy outside the U.S. The European Central Bank said on Dec. 8 that it will continue its very easy policy setting at least to the end of 2017, though it will scale back the extent of its “quantitative easing” buying bonds (to keep prices high and yields low) from April of next year. Similarly, the Bank of Japan, immediately after the Fed rate hike, said that as well as keeping the 10-year Japanese government bond yield around zero, it would also be buying longer-maturity bonds to keep 15- to 30-year yields low as well.

That said, bonds were always due for some eventual normalisation from their exceptionally low post-global financial-crisis levels, and even if the catalyst has come from a quarter that very few people had expected and has taken longer to happen than most people thought, it now looks under way. There is still a portfolio insurance case for global fixed interest–as Brexit, the Trump election, and the Italian referendum have shown, there is still a good deal of geopolitical uncertainty, and plenty of room for further upsets (the French presidential election, for example, or an Italian banking crisis). In uncertain times, bonds can often be an effective safe haven. But global economic fundamentals are currently running against the asset class and against the “bond surrogates” (infrastructure, property, high dividend equities) that investors had been accumulating in the previous era of ultra-low bond yields.

International Equities — Outlook

The latest data out of the U.S. have been mixed. The key indicator for financial markets is currently the jobs numbers, and they have been solid, but both November retail sales (up a marginal 0.1%) and industrial production (down 0.4%) fell short of analysts’ expectations.
In the current state of sentiment, however, the markets have been less concerned about near-term indicators and more focused on possible changes to policy – particularly personal and corporate tax cuts and increased infrastructure spending–which have the potential to boost GDP in 2017 and beyond and improve the outlook for corporate profitability. There may also be moves to address the problem of the very substantial profits U.S. companies have been holding overseas (because of the relatively high U.S. corporate tax rate) and which would also have various positive effects if encouraged to repatriate.

The improved outlook for the U.S. economy is evident in a number of areas. The Wall Street Journal panel of forecasters has upped its latest estimate of GDP growth next year to 2.4% (previously 2.2%) and will likely raise it further in coming months. And the first postelection business survey run by the National Federation of Independent Business, an industry group representing small businesses, showed sharp rises in expected business conditions: Before the election, business owners had been mildly downbeat on the outlook (the survey had shown a net balance of negative, but postelection business confidence had jumped up to 38.
The latest expectations for U.S. profit growth (collated from share analysts’ estimates by U.S. data company FactSet) are also encouraging. The currently expected 11.4% profit growth in 2017 for the S&P500 companies is distorted by a massive turnaround in energy company profits, but looking at the detail of other sectors, a good 2017 lies ahead for most of them (ex especially interest rate sensitive sectors, such as the U.S. REITs and the utilities). Expected profit growth ranges from 4.3% for industrials and 6.9% for consumer staples, at the lower end, to a robust 10.7% for financials and 10.9% for IT. Again, these numbers are probably going to be revised higher in coming months as the exact shape of the incoming administration’s policies becomes clearer.

Outside the U.S., the economic outlook in the main developed economies is less robust. In the U.K., conditions have been artificially boosted by the sharp fall in sterling, which has markedly improved exporters’ competitiveness, but the U.K. has yet to experience the reality of what is likely to be less favourable post-Brexit access to the eurozone. The latest data (on October jobs) showed that total employment dropped by 6,000 against an expected 50,000 increase, which may be an early signal that the immediate post-referendum pickup in activity may already be losing oomph. In the eurozone, conditions remain generally weak. Industrial production, for example, unexpectedly dropped in October by 0.1%: It had been expected to pick up after a 0.9% fall in September. And in Japan, the latest “tankan” business survey showed some modest improvement, but it was largely concentrated in the energy sector, and there is no clear sign that the overall economy is managing to accelerate.

Overall, a stronger outlook for the U.S., strong growth in some emerging markets (especially China and Russia), and little change to the subdued outlook for the eurozone and Japan add up to better prospects for global corporate profitability. In the latest (December) survey of institutional fund managers run by Bank of America Merrill Lynch, the respondents had turned markedly more positive about the outlook for global activity and for global corporate profitability (expectations are at a six-and-a-half-year high).Their asset allocations have correspondingly been adjusted towards equities (towards Japan in particular, which is seen as offering good value, but also towards the U.S., while the eurozone has been cut back) and away from bonds.

There is consequently something of a tailwind behind global equities, and it may persist well into the New Year as investors continue to reassess the outlook, with in all probability progressively higher expectations for the U.S. economy yet to be factored in. At the same time, the new bullishness needs to be tempered, as there are various wild cards that could derail the rally. One is progressively higher cash and bond yields: Equity valuations still contain some froth from relative valuation calculations based on historically unusual low cash and bond rates. Another is the absolute valuation of U.S. equities: After the recent rises, the S&P 500 is now trading on a trailing P/E ratio of 24.9 times earnings, a degree of expensiveness that could leave shares vulnerable.


Performance periods unless otherwise stated generally refer to periods ended December 13 2016



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