The Bigger Picture
Our economic scenario
With rising corporate and consumer confidence in most major economies and little upward pressure on prices, we expect this year’s return to synchronized global growth to continue. International trade volumes have picked up again, after dipping in the first half. And we continue to note signs of growth in corporate capital expenditure plans – Standard & Poor’s forecast an increase of 5.5% this year, after four years of decline. Within emerging economies, the picture remains encouraging, despite political risks and an expected easing of growth in China.
Although deflationary fears have dissipated as the global economy has gained traction, there is still little sign of price rises getting out of control. Unemployment is falling across the board, but we have yet to see meaningful upward pressure on wages, despite the closing in output gaps. Recent underlying inflation readings in the developed world have disappointed expectations and the oil-related boost to headline prices will continue to fade. The same holds true in many emerging economies.
This environment means that central banks can continue their very gradual move to tighter monetary policy. As expected, the US Federal Reserve has confirmed that it will shortly begin to shrink its holdings by only making partial reinvestments when bonds mature. And further hikes are in the pipeline. The ECB has made more hawkish statements, but it is likely to do little more than scale back its continuing asset purchases in the medium term. All in all, monetary policy is likely to remain largely accommodative in coming quarters.
How does this impact asset classes?
The last few quarters have seen the global economy experience a solid pick-up in output but with little sign of any inflationary pressure. The same combination holds true currently, albeit with some regional variations. This environment remains supportive for risk assets, although potential return is constrained by demanding valuations.
Eurozone and Japan have been leading the race
The eurozone and Japan continue to register above- potential growth. Both benefit from undervalued currencies, easy monetary policy and supportive fiscal policy. As a result, business confidence is high, job creation is robust and consumer confidence is rising.
In the United States, we expect a temporary hit to growth from the hurricane season. This could represent a reduction of up to 0.6 percentage points in third quarter growth, taking it to an estimated annualized rate of 2.0% after 3.1% in Q2. However, we would expect this to be followed by a boost to growth as reconstruction after the storm damage gets underway.
The United Kingdom remains a study in contrasts. On one hand, unemployment has reached half-century lows at 4.3% and business confidence remains relatively elevated. On the other, Brexit uncertainty is slowing foreign direct investment plans, and many businesses are preparing to shift part of their operations to the European Union (EU).
But the US and UK are not also-rans
In our previous edition (Glass Half Full), we cautioned that it would be imprudent to extrapolate recent trends into the future – investors had become too pessimistic about the US and UK economies, and rather too sanguine about the eurozone. And indeed, we have begun to see a shift in expectations. Tax reform, which investors had given up on, is back on the agenda in Washington. And Theresa May’s September speech in Florence has opened the door to more constructive dialogue with the EU-27 and an extended transition period, perhaps towards a less complete break with the EU.
Political concerns may remove some of the sheen
The optimism born out of this year’s Dutch, Austrian and French elections has given way to another bout of soul- searching.
In Germany, the populist-right Alternative für Deutschland became the Bundestag’s third largest party in the recent federal elections, and Angela Merkel’s CDU/CSU bloc (Christian Democrat Union / Christian Social Union) faces extended negotiations to form a workable three-way coalition. In Spain, the aftermath of the Catalonia referendum will require a fundamental rethink of the balance of power between the state and its regions. In Italy, the anti-EU populist Five Star Movement remains neck-and-neck with the ruling Democratic Party in polls.
However, strong growth will help equities perform
While political concerns may remove some of the sheen from the outlook for the eurozone, growth should remain well above trend. And the US should recover from its storm-related dip in coming quarters.
This represents a supportive environment for risk assets, and equity markets in particular. Studies demonstrate that equities tend to deliver outperformance in times of recovery and expansion, with the best potential coming in the early phases of recovery.
In this context, we continue to concentrate on those markets which rank best in our VaMoS framework. Equities should be preferred to fixed income, and the eurozone and Japan should be preferred within equities. The upside and downside risks we highlight above have the potential to impact markets in the short term. But we do not believe that they will alter the fundamental underpinnings, which remain supportive for equities.
This is a useful reminder that it is often better to focus on the bigger picture rather than get distracted by noise. As Warren Buffett wrote in the 2013 Berkshire Hathaway letter to shareholders: “Games are won by players who focus on the playing field – not by those whose eyes are glued to the scoreboard” Warren Buffett, 28 February 2014.
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