Surveys and hard data show the global economy growing at a healthy pace with minimal inflation risk. Activity accelerated in Q2 and our expectation of 3.4% GDP growth – marginally higher than last year – should be achieved in 2018. Although stronger US growth will continue, the OECD composite leading indicator suggests the global cycle has peaked, partly explaining why financial markets have become more sensitive to interest rate “normalisation” and the scaling back of ultra-accommodative policies, as well as escalating trade tensions and a 20% rise in Brent crude to around $80 a barrel.
Financial markets lost momentum in June after recovering strongly from the end-March lows. Technology and energy stocks supported the US S&P 500 with a gain of 13 points to 2718. The Japanese Nikkei 225 rose 103 to 22304 but the European markets fell; the FTSE Eurofirst lost 12 to 1486 and the UK FTSE 100 was 41 lower at 7636. After a good start to the year, emerging markets have lost their shine and are down just over 4% in 2018. US 10-year bond yields rose sharply in January but then tracked sideways to end June at 2.85%, 40bp higher on the year. The UK 10-year also rose but has since eased to 1.28%, little change on the month, quarter or year.
There has been little change in global GDP estimates and, while financial markets appear to view trade tariffs as a negotiating tactic with marginal impact on GDP, the uncertainty may already be damaging confidence and investment in the US and could be offsetting some of the benefits from the recently passed tax cuts. The initial 25% US tariffs on $50bn of Chinese capital and goods take effect at the beginning of July. When China retaliated, President Trump threatened to impose additional 10% tariffs on another $200bn of imports. It is impossible to quantify the impact but – with other measures including foreign investment, cloud services and semiconductors under consideration and US mid-term elections in November – trade tensions are unlikely to disappear.
2018 has seen a divergence in growth between advanced and emerging economies. The US is outperforming with activity re-accelerating in Q2 as the fiscal stimulus boosts net incomes and investment in business equipment. Although exports are growing strongly, improving consumer confidence is expected to increase demand for imported goods and widen the trade deficit. Higher productivity is helping to contain unit labour costs despite the Federal Reserve forecasting a fall in unemployment towards 3.5% later this year. Confidence in the economy has emboldened the Fed to signal that interest rates will rise faster, with 3% likely by early 2019. As market reaction to this policy shift was surprisingly muted, a further flattening of the yield curve can be expected over the coming months. For the time being, the prospect of higher rates and repatriation of corporate cash flows appears to be outweighing the deteriorating twin deficits and has helped to boost the dollar – especially against emerging market currencies.
China’s economy is also performing strongly, albeit with the pace slowing and the usual concerns about sustainability. The transition from investment/infrastructure to consumption continues with the latter now representing 75% of GDP. However, the economy may not be immune to slowing global trade and increased tariffs. Domestic disposable income has been growing faster than GDP in recent years at 7%+ annually and, while this is likely to continue as the ‘middle class’ expands, household debt has doubled in three years. The recent dip in retail sales to 8.5% year-on-year may be attributable to temporary factors rather than measures to curb demand but these policy adjustments suggest a high degree of sensitivity to maintaining 6.5% GDP growth. Most other emerging economies are growing in line with expectations but are being buffeted by slowing trade volumes, generally tighter financial conditions and a stronger dollar as cash is repatriated to the US.
Economic activity in Japan rebounded in Q2 as a result of improved net exports, consumer spending and business investment. Wages are static in real terms, however, so GDP growth is likely to revert to trend (around 1%) and the Bank of Japan to continue its loose monetary policy. The main downside surprise has been the Eurozone, where over-optimism after last year’s strong performance and slowing global trade have resulted in GDP estimates being lowered to 2%. Although Germany, France and Italy all face challenges, the picture looks more optimistic in Spain and Ireland which have benefitted from strong growth in employment, consumption and investment. Improving real disposable incomes has helped stabilise the UK economy but with GDP growth estimated at 1.3% for 2018, the pace of expansion significantly lags other advanced economies. Export growth is slowing despite sterling having weakened by just over 3% to $1.32 since the start of the year. With ultra-low interest rates, the savings rate at a near record low, and a highly leveraged housing market, any government stimulus has to come from fiscal policy – hence the rise in government spending. The Brexit negotiations have made little progress with frustration evident across a range of businesses and a drop in consumer confidence.
Monetary policy tightening lags the US with the latest guidance from the European Central Bank confirming that bond purchases will end this year and interest rates will not rise until next summer. The Bank of England has also revised its guidance to reflect economic reality and there is now only a 60% chance of a rate rise in August.
The threat of protectionism is likely to dominate headlines over the summer and – with institutional investors holding low cash balances – a meaningful market setback is possible. The ‘normalisation’ of interest rates and modest inflation will continue to be challenging for bonds but the rise in US yields means the 3% yield on 10 year Treasuries offers some value for investors seeking income. Corporate bonds will at some stage face the additional challenges of a maturing credit cycle and deteriorating balance sheets. These typically result in wider spreads, although the gradual approach by central banks suggests the short- term risks are limited. Merger and acquisition activity is likely to accelerate before the liquidity window closes.
For equities, the economic backdrop and favourable financial conditions should mean another good year for global corporate earnings with prospective valuations for most major markets towards the lower end of their 12 month range and in line with longer-term averages. This may partly reflect the de-rating that takes place as interest rates and inflation rise in the maturing phase of an investment cycle but could also be in anticipation of estimates being trimmed after the half-year reporting season as a result of the stronger dollar and management caution about trade tensions. Offsetting these risks is the strong corporate cash position that could mean bumper dividends/share buy-backs as the capex cycle peaks.