Global economic picture looks positive
The synchronised global upswing that started last year remains in place. Forward-looking economic indicators continue to be strong in most regions.
This is supporting investor demand for risk assets such as equities and credit. In addition, the first quarter earnings season was very positive, especially in the US. Corporate earnings continue to be revised upward.
Different stages of the cycle
There is still a divergence between the economic cycles of advanced economies. The US continues to lead the way in terms of growth and is at a later stage in the economic cycle. The eurozone is further behind with some countries – such as Germany – at an advanced stage in the cycle while others – such as Italy – are lagging.
This divergence in regional progress through the economic cycle explains why the monetary policy cycle has also diverged. The US is now raising rates while other central banks continue to keep monetary policy ultra-loose.
Despite the recent synchronised pick-up in growth, global GDP remains well below the level it could have reached had the global financial crisis not happened. This lost output may never be recovered.
It has a knock-on effect in terms of fiscal policy as tax receipts remain lower than they might otherwise have been.
Europe: out of the woods?
Turning specifically to Europe, the data keeps improving and suggests a further acceleration in growth. The forward-looking purchasing managers’ indices suggest a GDP growth rate of 2%, which is a good pace for the eurozone.
At the same time, there is no inflationary pressure so the European Central Bank (ECB) can keep monetary policy accommodative. The spectre of deflation has receded as growth accelerates.
Political risks have faded in Europe following the victory for pro-EU candidate Emmanuel Macron in the French elections.
The Italian general election, which must be held by May 2018, is now the biggest risk on the horizon. The anti-EU Five Star Movement continues to perform well in the opinion polls, but even if it were the largest party it would still need to form a coalition in order to govern. Moreover, if it were to call a referendum on Italy’s EU membership, it is not at all clear that it would win it.
Europe’s structural problems persist
While the acute risks related to elections have faded, Europe’s chronic structural problems have not gone away. Macron faces a sizeable task in reforming the French economy, although he does have a strong mandate to support his efforts.
The relative competitiveness of different eurozone countries remains a problem. Countries such as Germany, and France to a lesser extent, are able to keep a lid on unit labour costs. Peripheral economies such as Italy and Greece tend to find that any benefit from higher growth is soon eaten up by higher wages. Italy used to deal with this competitiveness problem by devaluing its currency but clearly this is not an option in the eurozone.
UK economy is weakening
The UK economy confounded predictions by holding up much better than expected in the wake of the June 2016 Brexit vote. However, it is now deteriorating.
Consumer spending was largely the reason why the UK economy continued to perform so well last year. However, consumer spending is now being squeezed by inflation and soft wage growth.
Weaker sterling means inflation is likely to rise further. Whereas higher inflation in other regions has been largely driven by the recovery of oil prices, in the UK the drop in sterling means higher prices throughout the economy, including clothing, food, etc.
At the same time as prices are rising, wage growth remains subdued. This implies that consumers will either need to reduce spending or that demand for credit will rise. Meanwhile, the savings rate has already fallen.
Brexit uncertainty weighing on business
While consumer spending held up post the EU referendum, business investment did fall as expected. Although a weaker sterling should theoretically provide a boost to exporters, it has not done so yet. This is likely because uncertainty over the UK’s future trading relationships is deterring businesses from engaging in long-term contracts.
The timetable for Brexit negotiations is extremely tight, especially given that ratification will be needed by individual parliaments. We continue to think that a transition, or implementation, period will be agreed. However, this would probably only happen as the Brexit deadline of March 2019 nears. In the meantime, uncertainty could weigh on business decisions and sterling may see further volatility.
Given this environment, coupled with the lack of inflationary pressure from wages, we continue to think it unlikely that the Bank of England would raise interest rates in the near-term.
US: Trump trade has faded
The election of Donald Trump was greeted with a return of animal spirits in the US as business and consumer confidence surged. Equity market investors focused on cyclical (economically-sensitive) stocks that were expected to benefit from Trump’s pro-growth plans.
That “Trump trade” has now faded away. Investors have returned to the higher quality, defensive assets that they favoured prior to the US election, along with technology stocks.
It seems this reversal is primarily due to worries that Trump will fail to push through his policy agenda. There are areas where we think he is unlikely to be successful. For example, the aims of growing the economy by 4% or adding 25 million new jobs look over-ambitious. However, we think it unlikely that Trump will make no policy progress at all.
US policy progress needed before midterms
New tax and healthcare legislation is crucial for the Republicans ahead of the midterm elections in November 2018. Should there be no progress on these issues, then the Republicans may find they lose their majority in the House and end up with a gridlocked legislature. If the Democrats took control of the House, they could potentially try to impeach Trump.
There are a number of other policy areas where we would expect the Trump administration to be successful in passing legislation. These include changes to rules governing the repatriation of overseas assets; deregulation in the banking sector; and a cut to the headline rate of corporation tax.
Emerging markets: calmer waters ahead
Emerging market assets have performed well recently, even as the US Federal Reserve (Fed) has been raising interest rates. One explanation for this is that emerging market currencies had already devalued substantially in 2015 and 2016, prior to the Fed beginning its current hiking cycle. With their currencies looking competitive, emerging markets are growing again. At the same time, central banks in emerging markets were raising interest rates while developed economies had low or negative rates. This means there is a cushion for rates to fall again if required.
Another positive for emerging market assets is that protectionist policies from the US have failed to materialise.
Are investors complacent?
Despite all that’s going on in the world – from US rate hikes to the crisis in Syria – the VIX index that measures market volatility is at very low levels.
While we have alluded to some risks above, there are good reasons for these low levels of volatility. It is true that the US may need to increase interest rates faster than the market currently expects. However, even if it did, overall global liquidity would still be abundant as central banks in Japan and Europe continue with quantitative easing.
Inflation might be assumed to pose a risk as the economic cycle progresses but wage growth currently remains contained in most major economies. This is partly due to increased competition amid globalisation but changing technology has also had an impact. For example, retail jobs are being shed as consumers switch to online shopping. As robotics advance in many industries, this is a trend that looks set to continue.
Overall we would argue that the market is not complacent, and we would also note the shortage of truly safe assets in which to invest. Indeed, investors’ preference for higher quality, defensive parts of the equity market suggests an acknowledgement that there are risks in the current environment. Similarly, technology shares are also finding favour as a long-run growth story that stands somewhat apart from near-term political or macro factors.