Global Economic Update (2017/May)

Defensive assets such as bonds and property have been lagging, and will be under further pressure, if bond yields rise over the next year

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Outlook for Investment Markets

Growth assets have performed well year to date, initially on the ”Trump trade” theme of a fiscally-stimulated U.S. economy, but more recently on the back of wider evidence of faster global economic growth and a happy outcome from the French presidential election. The stronger state of world business activity will provide further support for global growth assets, but there is little room for slippage. If corporate profits deliver to investors’ high expectations, all well and good, but the risk is that current expensive valuations (especially in the U.S.) are priced for perfection and could be vulnerable to setbacks. Defensive assets such as bonds and property have been lagging, and will be under further pressure if, as seems likely, bond yields rise over the next year—an exception is infrastructure, which remains in high demand.

International Fixed Interest — Outlook

Although the short-term direction of U.S. bond yields is at the mercy of volatile shifts in investor sentiment, the longer-term outlook is clearer. The likelihood is that the Fed will continue to tighten monetary policy by raising interest rates, which will affect the shorter end of the yield curve, and will also move to reduce its bond buying programme, which will affect the longer end of the yield curve.

In both cases, the rationale is clear: the U.S. economy has continued to progress, with the rate of unemployment now down to only 4.4%, which means the economy no longer needs aggressive monetary policy support, and inflation has risen close to where the Fed would like it to be, so it too needs little or no further boost. The key measure for the Fed is the “core personal consumer expenditure deflator,” which on its latest reading (1.8% in March) was effectively at the Fed’s 2% target level.

The upshot is that the Fed will very likely continue to raise the federal-funds rate from its current 0.75%–1.00% target range, most likely starting with another 0.25% increase at its June meeting, and probably raising it by another 0.25% by the end of the year.

In addition, the Fed is likely to stop reinvesting in bonds as its quantitative easing, or QE, holdings mature, and instead will let its outstanding holdings gradually run down over a long period of time. The timing is still uncertain, but market surveys suggest that bond investors think the Fed will stop reinvesting in bonds sometime next year, and will have the effect of taking a major bond buyer out of play. Reduced demand is likely to lead to lower bond prices and (equivalently) higher bond yields.

The outlook for U.S. dollar bonds is consequently challenging. Assuming nothing happens to derail the U.S. or global economies and to reignite “safe haven” bond buying, the latest consensus estimate (from the Wall Street Journal’s May poll of forecasters) is that by the end of 2018, the 10-year U.S. Treasury yield will be a full 1% higher, at 3.3%, than it is today, which would imply a capital loss of some 8% on the benchmark Treasury.

There is likely to be less pressure on still ultra-low bond yields in other major markets, but they too will face some headwinds: a combination of the knock-on effect of higher U.S. yields and the eventual prospect of normalisation of their own monetary policies. For the time being, the European Central Bank is still in full stimulus mode, including adding to its QE hoard of bonds, but the progressively strengthening eurozone economy will likely lead to a change of course some time next year. And the Bank of England has also said that it might have to raise rates a bit earlier than the markets currently expect, though its timing looks to be more like 2019 rather than 2018. Only in Japan does it look likely that bond yields will be kept very low for the indefinite future.

While bonds always carry some useful insurance value—and as noted elsewhere, investors in the equity markets appear to be ignoring potential risks, so some insurance against nasty surprises may well be worthwhile—overall, the economic fundamentals are running against the asset class.

International Equities — Outlook

In the U.S., the latest data has been a mixed bag. Although the single most-watched indicator, new jobs, has been doing well (211,000 new jobs in April, at the upper end of expectations), and consumer confidence has been rising, both April’s retail sales and April’s inflation rate came out a little lower than expected, hinting that the economy may not be running as strongly as anticipated. Even so, the latest data look more like a wobble than a shock, and forecasters remain confident about the outlook. The Wall Street Journal panel of forecasters is picking that the U.S. economy will grow by 2.0% to 2.5% this year and in 2018 and 2019, and it is also becoming less worried about downside risks with the panel putting only a 15% possibility of a recession within the next year, down from 20% a year ago.

The news from the rest of the world is also good, particularly in the formerly sluggish eurozone where a wide range of indicators are pointing to an acceleration in economic activity. The latest IHS Markit eurozone “composite” surveys (taking in both manufacturing and services) “portray an economy that is growing at an encouragingly robust pace and that risks are moving from the downside to a more balanced situation.”

Markit aggregates its national and regional purchasing manager surveys into a global aggregate, the J. P. Morgan Global All-Industry Output Index, and it too is travelling well, with the latest (April) reading showing that “Growth of global economic output was maintained at a solid clip at the start of the second quarter.” When sliced by industrial sector, the global survey shows that, remarkably, every single sector is currently in expansion mode, with the strongest rates of growth being seen in technology, the industrials, and healthcare.

The economic backdrop for corporate performance consequently looks reasonably good. In the U.S., for example, share analysts (on the data compiled by data company FactSet) expect that profits for the S&P500 companies will increase by 11.8%. While the figure is distorted by a massive turnaround in the energy sector (where profits are expected to soar by 45%, due to higher energy prices), most sectors (excepting real estate, the utilities, and telco services) look set for solid profit growth.

But, as has been the case for some time, the positive outlook needs to be tempered by noting expensive equity valuations and potential investor over optimism. Valuation concerns are especially severe for the U.S. market—while, as noted, investors expect strong profit growth, they are also paying substantially more for it than they normally would. Estimates of the forward-looking price/earnings ratio vary in detail—the ratio is around 17.5 times expected profits, give or take—but agree that whatever the exact number is, it is well above normal. Some of this reflects the world of unusually low interest rates, where investors have been prepared to pay more for nonbond assets, given the very poor value on offer on fixed interest. But that support is on the turn as bond yields threaten to rise. All may yet turn out well, but a combination of pricing for corporate performance perfection and a deterioration in relative equity-bond value makes the future going rather harder.

The other potential issue is investors’ apparent disregard of potential risk. The most widely publicised example is the unusually low level of the VIX, the measure of investors’ expected volatility from holding the S&P 500 Index, and which has headed even lower in recent days. But going by similar indices for other asset classes, investors are also expecting unusually little turbulence in, for example, European equities, global bond markets, and foreign exchange markets.
Again, events might pan out just fine, and there have even been some pleasant upside surprises, notably the French presidential election result, but investing is a road with bumps in it, and investors expect to be compensated for the risks they run. Currently, they may be underestimating the likely potential for unexpected upsets, and consequently paying too much for assets that carry more risk than they are allowing for.

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



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