Global Economic Update (2017/Sep)

The world business cycle continues to improve, providing a generally good backdrop for corporate profits

Morningstar Analysts 28 September, 2017 | 11:22
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Outlook for Investment Markets

World financial markets have become less concerned about North Korean risk: equities have largely recovered from previous setbacks, and ”safe haven” buying of government bonds has eased back. Whether the more relaxed mood is warranted remains to be seen. On the economic front, the world business cycle continues to improve, providing a generally good backdrop for corporate profits, though partly countered by some major central banks readying to remove some of their previous monetary policy support.

International Fixed Interest — Outlook

Conditions in global bond markets remain highly unusual, with investors finding very little yield on offer. In the past week, for example, the Austrian government has been able to raise euro 4 billion at a yield of negative 0.165%, and investors looking for a positive yield are still being forced to go to unusual lengths to find it. Austria also issued another bond in the same week, with a 100-year maturity, on a yield of 2.1% and press reports say there was strong investor demand. Investors have also been forced into higher-risk and off-the-beaten-track options. Corporate treasurers have been delighted to supply the demand. According to U.S. data company Dealogic, some USD 340 billion of high yield debt has been issued year to date, which is a 38% increase on a year ago.

These unusual conditions have repeatedly wrong footed previous expectations of bond yields moving back to more normal levels, and have persisted longer than practically anyone imagined. That said, there is now more solid backing for the view that conditions are finally on the turn, as central banks finally start to remove the ultra-supportive monetary policy that had kept bond yields abnormally low for so long.

The key central bank is the Federal Reserve, or Fed, in the U.S. While U.S. inflation has generally been running lower than preferred, and has needed more of an enduring fillip from the Fed than originally anticipated to get back to 2%, it now looks as if monetary policy will be gradually nudged further away from its present very stimulatory setting. FED met on September 19-20 and annouced to begin unwinding stimulus in October and leave interest rate on hold. And there is a chance to raise raise rate again this year. The latest FedWatch calculation indicates that FED is likely to raise rate in December.

Forecasters consequently expect a gradual rise in bond yields, with the latest (September) Wall Street Journal poll of U.S. economic forecasters expecting the 10-year Treasury yield to rise to 2.6% by the end of this year and to 3.0% by the end of 2018.

The Bank of England, or BoE, in the U.K. is also moving towards tightening. Unusually, it is a rare example of a central bank where inflation is above the official target (2.9% in August compared with the BoE’s target 2%), and with unemployment at its lowest since 1975 (4.3% in the May-July quarter), the bank said at its September 14 policy meeting that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.” The futures market now expects a 0.25% increase before the end of this year, whereas before the latest meeting, it had expected the first increase to come sometime in the back end of 2018.

The European Central Bank, or ECB, does not have the same inflation problem with eurozone inflation at 1.5% in August, below the ECB’s 2% target, but given the improvement in the eurozone economy, it too has started to feel that ultra-supportive monetary policy is no longer needed. It has said that it will announce its plans for winding back its QE programme at its October policy meeting. Forecasters think the ECB is likely to taper, that is gradually reduce, the amount of bonds it buys each month over the course of 2018, and may not be buying any more bonds at all by end of year.

Geopolitics might yet throw a large spanner into the works, and monetary policy might not be able to proceed in the nice orderly fashion currently expected. But if it is, of the major central banks, only the Bank of Japan looks set to continue with indefinitely easy monetary policy: the others will be carefully, and gradually, moving from very easy policy to less so. The good news for investors is that modestly higher yields are on the foreseeable horizon, with the bad news that it will take a period of capital losses to get there.

International Equities — Outlook

On the economic front, the outlook remains positive. The latest (August) J P Morgan Global All-Industry Output Index shows a good pace of global economic activity: “Overall growth was the quickest since April 2015, underpinned by expansions across the six main categories of manufacturing and services covered by the survey. With new order inflows strengthening, backlogs rising and jobs growth accelerating, the economy looks set to perform well in the coming months.” By sector, the index also showed that technology, and pharmaceuticals and biotechnology, in particular, are the fastest growing sectors, which shows that there is a fundamental underpinning for the sectors’ recent popularity with investors.

Forecasters are also upbeat. The Economist in London surveys a panel of international economic forecasters every month, and its September poll showed that every one of the 25 countries in the survey is expected to grow in 2018. The emerging markets are expected to be particularly strong, with India expected to grow by 7.5% (up from an already impressive 7.0% for this year) and China by 6.5%. The Economist also makes its own forecasts for countries outside the most important 25: every single one of them is expected to grow in 2018, other than grossly misgoverned Venezuela.

This would normally be clearly supportive for world equities, but one significant qualification is that the positive outlook is already well built into prices, particularly in the U.S. which is the most expensively valued of the major markets. Currently, the share market analysts surveyed by U.S. data company FactSet have ambitious expectations for American shares in that they expect profits for the companies in the S&P500 Index to grow by 11.0% in 2018, and the index to rise by 10% over the next year. This is achievable given the ongoing growth in the U.S. economy, but it also leaves little leeway for earnings disappointments if companies, or the economy more generally, do not live up to expectations.

Another potential issue is mis-steps by one of the major central banks in withdrawing the current degree of monetary stimulus. As noted earlier, all the central banks look to be approaching the process with a high degree of caution and care, but the equity markets have been roiled by a “taper tantrum” before, and might be hit again. Economic considerations may however take a back seat to geopolitics in coming months. Nobody knows how the current North Korean difficulties will play out, or whether currently quiescent hot spots in the Middle East or the Ukraine (among others) will stay that way. Investors (going by the VIX gauge of expected S&P500 volatility) are either robustly confident (on a positive view) or blindly complacent (on a negative view). The VIX has recently signalled some degree of investor nervousness with it spiking twice in early- to mid-August and again in early September, but the equity market showed remarkably small levels of alarm given the potential threats from a nuclear-armed, hostile and erratic North Korean regime.

The rise in the VIX, for example, was not especially large (the markets were less worried, for example, about nuclear North Korea than they had been in early 2016 about a potential slowdown in the Chinese economy), and did not last, with the VIX now back to “all clear” levels.

All going well, the clear evidence of a strengthening world economy will carry the day, and global shares will be able to make further gains. But there is a higher than usual probability of left field geopolitical surprises making their presence felt. That may well be why the big fund managers in the latest (early September) Bank of America Merrill Lynch survey reported increased levels of insurance protection against equity market corrections in the next three months.

 

Performance periods unless otherwise stated generally refer to periods ended September 15, 2017

 

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