Global Economic Update (2017/Mar)

Asset valuations generally remain expensive, and are vulnerable to any unexpected adverse shocks

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Outlook for Investment Markets

Both growth and inflation have been picking up globally. Higher economic growth has been, and will continue to be, helpful for equities, but rising inflation will also be challenging for bonds and other income-oriented asset classes. Asset valuations generally remain expensive, and are vulnerable to any unexpected adverse shocks, especially as investors appear to be factoring in low levels of concern about the probability of political or other surprises.

International Fixed Interest — Outlook

The Fed’s latest move is likely to be the first of several. On average, the officials involved in the decision expect a further two 0.25% increases during the rest of this year, and two or three more during 2018.

The Fed’s rationale is quite simple: inflation is heading back to where the Fed wants it to be (it expects its preferred measure of inflation to be 1.9% this year, and bang on its preferred 2.0% target in 2018 and 2019), and the economy is doing well. From both perspectives of its dual inflation and growth mandate, there is no longer any need to maintain its previous very stimulatory stance.

Much the same applies in the eurozone, where until very recently, the European Central Bank, or ECB, was expected to keep monetary policy on a very stimulatory course for some considerable time. Again, evidence of rising inflation and an improving eurozone economy mean the previous need for ultralow interest rates and “quantitative easing” (purchases of bonds to keep longer-term interest rates low) is now past. Further rate cuts are off the agenda, as the ECB governor Mario Draghi said this month, while outright interest rate increases are still unlikely in the near future, the ECB is now likely to start thinking of paring back its bond-buying programme as a first step towards normalising interest rates to more usual levels.

In summary, the outlook for global bonds is likely to become progressively more difficult. Monetary policy is becoming less supportive, and inflation is rising which is a combination that is unfriendly for fixed interest. Barring large geopolitical or financial shocks, which might send investors back into the relative safety of high-quality bonds.

International Equities — Outlook

The outlook for world equities has not changed. The major elements are an improving outlook for global economic activity, but set against high valuations and low preparedness for any adverse surprises.

On the economic outlook, the key indicator the financial markets are interested in is the trend in U.S. employment. It has continued to deliver good news. January had been strong with 238,000 net new jobs, and forecasters had been expecting a slightly lower outcome for February around the 200,000 mark. The number came out on a par with January, with 235,000 jobs, and the unemployment rate dropped from 4.8% to 4.7% despite more people deciding to enter the labour force (there was a rise in the “participation rate,” itself a sign of job seeker confidence in the availability of jobs).

Beyond the U.S., the outlook for global economic activity has also been positive. The February Markit/JP Morgan Global Composite Indicator was mixed, with manufacturing growing a bit faster but services not growing quite as quickly as previously. However, overall the index showed, as Markit said, that “the all-industry PMI remains at a level consistent with solid, above potential growth of global real GDP. Continued job creation and rising new order inflows suggest the current upturn maintains sufficient momentum to carry growth forward during the coming months.” Most sectors are solidly optimistic about the year ahead, with software, telecoms, “other” financials, (that is, not banks or insurance), technology equipment and beverages the most upbeat. Not a single sector was outright pessimistic about the outlook, although real estate, tourism, the media, and mining were less upbeat than the rest of the pack.

In particular, the previously lagging eurozone has been coming to life. In words that nobody would have expected to read even a few months ago, Markit said about the latest data that the European numbers “paint a bright picture of a eurozone economy starting to fire on all cylinders...The labour market is also starting to boom, with jobs being created at the fastest rate for nearly a decade.”

In other major economies, the outlook is not so straightforward. The U.K. is entering the actuality of Brexit, and although its economy has done better than expected thus far (mainly due to the competitive advantage of a much lower British pound), it is now moving into more difficult territory where its trade access to European markets may be compromised. Japan also is relatively weak. Markit’s February Japan Business Outlook found that “Japan’s private sector recorded the second lowest level of business confidence amongst all the global economies covered in the Outlook series, highlighting how not all firms are optimistic that the recent upturn in the economy can be sustained over the coming year ahead.”

Overall, however, the major economies have improved, and the global outlook has been helped significantly by ongoing rapid growth in many of the big emerging markets. The latest (March) consensus forecasts collated by the Economist magazine have China, for example, growing by 6.5% this year and 6.3% next, and India is growing even faster again, with 7.2% growth expected this year and 7.3% next.

While the macroeconomic fundamentals remain supportive for equity performance, the main issue is that valuations remain on the expensive side of historical yardsticks. In the U.S., for example, on data company FactSet’s estimates, “The forward 12-month P/E ratio for the S&P 500 is 17.7” (other estimates put it a little higher, with S&P making it 18.1 and Birinyi Associates 18.3). As FactSet notes, “This P/E ratio is above the 5-year average (15.0) and the 10-year average (13.9).” These valuations may well rise as investors increasingly turn to equities as the asset of choice when faced with progressively more difficult bond markets.

These valuations leave little room for things to go wrong. Currently, investors are happy, for example, with the good news on jobs out of the U.S. But the economic projections made at the latest Fed policy meeting were quite modest: GDP growth of 2.1% this year and next, and 1.9% in 2019; and unemployment is expected to drop only a little more, to 4.5%, and to stay there over the next few years. It would not take much for a few months’ unexpectedly low jobs numbers to puncture current levels of optimism. Another signal of complacency about risk is shown by the VIX index of the volatility investors expect to encounter from holding the S&P500. After a brief rise on the unexpected Trump election, it has dropped back to unusually low levels—levels consistent with investors expecting few or no clouds on the horizon.

It would be nice if the global economy always grew steadily and its politicians always played well with others. But that is not typically how the world works, and current valuations are priced for a more stable environment than is likely to evolve. The economic fundamentals remain a solid support, but it would be surprising if we get through the rest of the year without some reality checks.

 

Performance periods unless otherwise stated generally refer to periods ended March 17, 2017

 

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