The global economy is still expanding although the pace is no longer accelerating. The eurozone and Japan continue to register above-trend growth, and the US should pick up after a sluggish start to the year. Global trade volumes have risen, investment spending has begun to improve and falling unemployment has bolstered consumer confidence and spending. Emerging economies will contribute more to global growth than in recent years although we do expect China to slow as the impact of 2016’s stimulus package fades.
The boost to inflation from last year’s surge in oil prices is beginning to dim, leading to concerns that deflationary pressures might reassert themselves. We believe this may prove misguided. Output gaps are beginning to close and unemployment is falling throughout the developed world – this will translate into wage pressures in due course. While it may take time to reach central banks’ 2% inflation target, we expect a moderate but steady rise in inflation, even excluding volatile items.
In light of synchronized global growth and rising inflationary pressures, we expect that gradual normalization of monetary policy will continue. We believe the US Federal Reserve will hike once more this year and also announce a cut in their programme of reinvestment of maturing bonds. While the European Central Bank and Bank of England will continue to sound more hawkish, we do not expect any tightening measures this year – the ECB is however likely to open the way to a decrease in volumes of asset purchases, to be implemented next year.
Investors experienced a bout of nerves in the aftermath of the Brexit referendum and US presidential election, fearing that Europe’s elections in 2017 could yield similar shocks. In the event, these worries have proved unfounded so far and indeed the overall environment has been much more benign than expected.
Political mayhem was avoided in Europe
Mariano Rajoy’s minority centre-right government remained in power in Spain, far-right populists failed to create upsets in either the Austrian presidential election or the Dutch parliamentary poll and – perhaps most significantly – Emmanuel Macron won the French presidency with an explicitly reformist and pro-EU platform.
It must be noted that the economic backdrop in Europe has improved. Unemployment continues its steady fall, business confidence has strengthened in both manufacturing and services and consumer sentiment recently hit a 10-year high. This environment is bolstered by a powerful combination – the euro is undervalued, monetary policy is exceptionally easy and governments have backed away from fiscal austerity. In addition, the recent rescue packages for banks in Spain and Italy suggest that a more pragmatic approach to solving the financial system’s woes is gaining traction.
But not in Washington and Westminster
Theresa May’s inability to achieve an enhanced majority in June’s snap election has added another level of uncertainty surrounding the Brexit negotiations. First quarter GDP growth was revised down and devaluation-induced inflation is eating into household confidence and disposable incomes.
In the US, the boost to small business confidence that followed Donald Trump’s election has yet to be justified by progress on the President’s flagship reforms to trade policy and taxation. And the economic surprise index calculated by Citi has plumbed depths we have not seen since 2011.
However, we would not sell US and UK assets...
First of all, with hope on Trump reforms at rock-bottom, any progress on healthcare reform, deregulation or the tax code would come as a welcome surprise to investors. Second, the US economy continues to create numerous new jobs and with core inflation rising only gradually, it looks unlikely that the Fed will be forced to tighten policy to the point where growth potential would be choked. Finally, economic surprises tend to come in waves – after a long period of negative surprises, economists tone down their forecasts opening the way for a cycle of positive surprises.
Within the UK government, some calls for a more pragmatic approach to Brexit negotiations – most notably from Chancellor Hammond – have been voiced. It is possible that Mrs May’s poor electoral performance could encourage a leadership challenge, and any inkling of a “softer” Brexit might spark a reappraisal of the downside risks for sterling.
...and downside risks remain in the eurozone
In Italy, where there is still talk of a snap election, the populist Five Star movement has been leading the ruling Democratic Party in most polls since late February. In Spain, Prime Minister Rajoy’s minority government could yet face a challenge from the upsurge in support for the left-wing PSOE. Also, there remains a risk that Emmanuel Macron’s labour market reforms could provoke widespread protest and strikes.
So, don’t extrapolate recent trends into the future. The outlook for the eurozone has improved but downside risks remain. And while the challenges faced by Prime Minister May and President Trump are daunting, they are not insurmountable.
We still recommend a moderately risk-on stance
The expansion currently underway in the global economy is supportive, as are the pick-up in earnings and the improvement in fundamentals. Valuations are high on average, and investors should favour markets which have catch-up potential, such as the eurozone and Japan. Price momentum is strong across the board, but some sentiment indicators – such as implied volatility – show signs of complacency. Well-diversified holdings across asset classes and investment themes should enable investors to capture the upside potential without taking on undue risk.
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