Economic Update

Executive Summary

 

• The US economy continues to remain healthy and this should continue for the next 6-12 months.
• Economists are ratcheting up their forecasts of US GDP Growth and US Corporate earnings.
• The FED is responding to US Macroeconomic strength with a steady program of quarterly rate hikes. The FED has not taken away the punch bowl yet, but with the US labour market pushing to full employment, and core inflation at 2%, there is strong impetus for the FED to gradually move interest rates into restrictive territory.
• The Australian economies growth has been impressive so far in 2018 but is likely to have peaked. The headwind of falling house prices continues to increase and uncertainty around the strength of the Australian consumer remains given high private debt levels which make Australia vulnerable to a global rising cost of capital.
• In Asia, Chinese growth seems to have stabilised and stimulus may even provide a small boost to activity in the region in the latter part of 2018. We expect a robust performance from the Japanese economy into 2019.
• We continue to watch the US 10-year treasury yield which has spiked from 2.0% a year ago, to 3.0% today.
• Our medium-term view on interest rates is there is now a rising risk of inflation accelerating to a point where Central Banks will need to tighten more aggressively than anticipated by markets. This could put pressure on asset valuations which have been priced assuming a low inflation, low interest rate regime is likely to prevail indefinitely.
• Our overall view on valuations has not changed materially. Asset prices generally look expensive with the US market being one of the more expensive markets and Australia, only slightly above fair value.

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The Global Economy

The global economic expansion appears to be continuing at a reasonable pace. We still see global growth at something like long-run average, or slightly above at present. But things have become more complicated after the heady talk of synchronised growth at the beginning of the year.

United States

We still believe that there is a risk of the US economy overheating in the next few years. The economy is fully employed, growth in labour costs is slowly rising, and anecdotes of tightness on the supply side have become more common – from difficulties of getting labour, to shortages of capacity in transport services. Growth in the first half of 2018 was above potential. Fiscal policy is stimulatory and monetary policy, while adjusting, could not be described as constrictive yet. Trade policy will not likely have a major effect on the US economy in the near term; in any event, trade policy tools are being deployed mainly in pursuit of US strategic interests, so any adverse economic effects are likely to be regarded by the Administration as second order. But what economic effects there are will work in the direction of tightening the supply side and raising prices. That’s the point of protectionism after all.

So, while a rapid surge in inflation does not appear to be imminent, a slow-burn build-up appears more likely than not, unless one has very strong faith in ongoing effects of price level deflation resulting from technology, globalisation and disruption etc… Bear in mind, too, that the Administration’s overt intention is to restrain or even reverse at least some of those forces. Mr. Trumps administration seems consciously to be seeking economic disengagement with China.

It is still the case that long-term interest rates in the US seem sceptical to the economy’s strength. 10-year yields are below the current and likely near-term rate of nominal GDP growth, even as the short end continues to shift higher. As many have noted, if the Fed stays on its present course and nothing else happens, the yield curve will invert within a year. While an inverse yield curve has not been an infallible forecaster of recessions in the past, its record is pretty good.

We are approaching a very interesting and critical time in US financial markets. Is the bond market signalling something about the growth and inflation outlook that the Fed isn’t seeing? Or is it the bond market that is missing something – perhaps the extent of overheating that could occur?

One new element is the President’s jawboning about interest rates. If, as appears, President Trump’s notion of Making America Great Again involves allowing the economy to run on full steam, it will be unwelcome if someone ‘takes away the punch bowl’. We believe the Fed will ignore this verbal intervention, as they should. Conditions haven’t yet tightened enough to allow any resistance to further tightening to gather any political strength beyond the President’s tweetstorm. The Fed should remain in control of monetary policy.

The Fed however, does not control US exchange rate policy. That is the preserve of the Administration – often implemented via commentary by the Secretary of the Treasury. The current policy settings with fiscal easing, monetary tightening, full employment, and with the US leading the international growth stakes quite comfortably – would, appear to be a set of conditions highly conducive to US dollar strength. A rising US dollar does act to water-down the punch at the party.

We do think there is a reasonable chance that the Administration, unable to deflect the Fed from its course, will choose to exert its discretion in the exchange rate arena. Outright intervention seems unlikely, but periodical jawboning of the US dollar would be a relatively easy tactic to employ. Were that to become a more regular occurrence, the term ‘currency wars’ may come very much back in to vogue, and key bilateral rates like the EUR and especially the RMB could get more volatile.

Meanwhile the trade war continues to escalate, with some European targets now in the Administration’s sights. Turkey, which is among the top ten sources of imported steel for the US, was hit with a tariff announcement while already reeling from a currency collapse. Turkey has for a while had many of the ingredients for trouble in a world in which US interest rates and the US dollar are trending higher: a substantial current account deficit, US dollar borrowings, domestic budget deficit, a nasty political regime.

Thoughts of investors naturally turn to potential contagion, and to analyses of which other emerging markets have similar characteristics. It is always a challenging experience for emerging markets in this stage of the credit cycle.

What is different about this administration, is it has become comfortable acting in a way that seemed to add to instability in markets. This contrasts with previous American behaviour which sought to calm things at times of crisis. It is almost twenty years since ‘the committee to save the world’ – Rubin, Summers and Greenspan – appeared on the front cover of Time magazine. Such US efforts had perhaps mixed success over the years, and the US was not above using crises and their influence at international organisations to push political or strategic interests. But at least we knew that, in the end, the US would try to contain financial turmoil, because it saw such action as in its own interests, recognising the interconnections in the system.

It is hard to be confident that the current Administration sees those connections in the same way. At least not yet; should turmoil in emerging markets or Europe feedback to American asset values, that may change. At present, Trump playing with matches seems to be fun, and perhaps wrong-footing the leadership of other nations is a tactic that the administration feels is working.

China

In China, GDP growth is shown as steady at a year-ended pace of about 6 ¾ per cent. Under the surface, of course, there is a lot going on. While bottom line growth has not changed much, some components have shown signs of more appreciable slowing. The backdrop is the intent of the policy makers to de-lever the economy, but without causing a crash. This is a hard balance to strike in any country; few have managed it.

At this stage, the evidence suggests some success in bringing the credit boom to earth reasonably gently. But it is early days and certainly way too early to draw any strong conclusions about how successful the deleveraging strategy will be.

In any event, Chinese economic policymakers don’t seem to be inclined to take too many chances. Policy has lately been in easing mode again. Whether this is due to discomfort about those impacts of the deleveraging strategy that are apparent, or whether it is due to concerns about the likely impact of US trade policy on the Chinese economy, is an interesting question.

For the moment though, it seems that China continues to grow, and policy makers are once again erring on the side of growth rather than restraint. Interest rates have fallen, reserve ratios have been reduced, and the yuan has depreciated.

So far, the impacts of the trade war with the US have been negligible. If China begins to experience export weakness, it is likely they will respond by attempting to boost domestic demand via targeted stimulus. The fact remains that US business just won’t be able to find the low wage workers or production capacity to replace Chinese imports. This will add upward pressure on US inflation and interest rates. So eventually Trumps tariffs will start to hurt US businesses and voters. At this time, we still believe Trump will follow the precedents of his conflicts with North Korea, the EU and Mexico. He will likely “make a deal” that fails to achieve his stated objectives but allows him to claim a “Win”.

Europe

Growth in the euro area, which was accelerating in late 2017 has moderated – back to Europe’s more conventional pace of 1- 2 per cent. This is, no doubt, a bit disappointing to some European policy makers, especially those hoping for an earlier return to more normal policy settings.

It makes the return of inflation to the ECB’s ‘close-to-but-below-2-per- cent’ objective on a sustainable basis seem like it is still a little way off yet. CPI inflation is 2-ish at present due to energy price lifts, but core rates are still about 1 per cent. So, the ‘below 2’ part of the ECB’s mandate seems more in operation than the ‘close to 2’ part. That hasn’t stopped ECB President Draghi proceeding with announcing a taper of the ECB’s asset purchases, but it seems an actual lift in rates is some time away yet.

Still, the step down in growth doesn’t seem to be developing into anything more sinister. It is more a case of back to the ‘same old’ growth performance we normally expect in Europe, where demographics and structural rigidities combine to keep potential growth low and where ongoing financial difficulties – e.g. in Italy – remain a steady headwind.

Australia

Locally, it appears the economy has been performing better than one would think given the political backdrop. The NAB business survey readings have been at levels that are about as good as it gets. Some moderation from those levels is still consistent with quite reasonable growth.

Employment growth has been slower this year than last, but 2017 was exceptional: you don’t get 3 plus per cent annual growth in employment very often. The mining investment downturn has ended, and things are looking up in some of the mining areas. Some state governments are running infrastructure programs of substantial size. The extent of improvement in the Federal Government’s finances has also been quite noteworthy and has changed the complexion of the government’s economic narrative. We are not back to the ‘tax cuts and a surplus every year’ world of the mid 2000s, but things seem a good deal easier on the fiscal side than they were a couple of years ago.

It seems that the main thing people have to complain about is slow wages growth. Even there, the minimum wage is still rising at 3 per cent, which is a reasonable lift in real terms; it is people in the middle of the income distribution that have seen the bigger squeeze over recent years. Part of the reason for slow wages growth, of course, is slow price growth, and vice versa. Inflation is a bit low compared with the RBA’s target, but only slightly.

House prices have been declining a bit but that was always on the cards after such a strong run up, and it is hardly unprecedented. While the tightening of lending standards has been credited with causing this, probably at least as big a factor is simply that ‘affordability’, or lack of it, ultimately constrains prices unless interest rates keep falling and/or credit standards become ever more relaxed. Neither of those has happened and are likely to tighten further in the years ahead.

In addition, as the Reserve Bank started to say more than two years ago, quite a bit of supply is coming on stream. Eventually supply responds to demand, even though that takes quite a while, and the market becomes more balanced. That is actually the system working.

Despite all the talk about financial stress, households’ arrears on loans remain low. Admittedly that is with interest rates very low, with competition for the marginal owner-occupier borrower very much alive. Still, most observers seem to be thinking that rises in official rates will be a while coming yet and will probably be very gradual when they do come – just as has been the case in most other places around the world. In our opinion, while we expect house prices to moderate further, a “crash” as hypothesised by a recent 60 minutes story looks very unlikely in the next 12-18 months unless there is a deterioration in the global economy.

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So the international expansion continues, but with plenty of worries for market participants to fret about. And while the near- term future seems still to be one of growth, it also seems to be shaping up as one where a slower pace of globalisation, and perhaps de-globalising in some cases.

If so, this may in time pose some big questions for highly trade-dependent economies, especially in Asia. To add to that, the emerging world may be less clear, and less confident, about what sort of safety net, if any, remains in place should they get into trouble. Perhaps all of us are less certain about the rules of international commerce now. We believe it is this uncertainty that is acting to temper animal spirits and extend the current economic expansion. Short of Trump escalating the trade/ economic conflict with China, the US should continue to grow at pace for another 12-18 months before a slowdown in late 2019-2020.

Consequences for Asset Allocation and Portfolio Construction

So how are we thinking about investing at the moment? Generally bullish over the next 6-9 months, but nervous. This long into an economic expansion, generally investors are complacent and valuations for major asset classes appear stretched. The table below from Perpetual’s multi asset team shows that their current 5 year forecast return for most asset classes is well below long term return expectations. While long term forecasts are very useful in telling us where valuations are today, even if they prove to be correct they generally aren’t useful predictors of shorter-term returns.

While valuations are suggesting we should be thinking defensive, there are risks in doing too much too soon. The US S&P500 has been the best performing regional market so far this year. With fiscal stimulus set to continue into 2019 we expect the earnings momentum to continue to drive the US market higher even as the cyclically adjusted Shiller P/E touched 33 times its 10-year average, which is the highest level ever outside of 1929 and the late 1990’s. Currently in the US, Q3/18 consensus EPS looks likely to be up around 25%, economic activity remains robust and business sentiment remains high. Over the next 12 months these quarter on quarter comparisons will become more difficult, but growth should remain strong for at least another 6 months.

Emerging Markets are the one place valuations looks attractive as they have been sold off due to $USD strength and trade concerns. While they appear oversold, we believe the risks of an escalated trade war and a stronger $USD on the back of further US rate rises auger caution for now. They may well get cheaper before they find a bottom. Certainly, we are watching this space, but feel it is too early to go into EM just yet.

In credit markets there is a historically narrow gap between yields on below-investment-grade corporate debt and “risk-free” U.S. Treasures. In other words, investors are demanding less of a premium to hold riskier debt. This indicates that credit markets still feel a recession is some time off. The negative for us as investors though is we are not being paid very much to take the additional risk to lend to corporates. Before each of the last 3 US recessions credit spreads have widened and we expect the same to occur before the next downturn. For the time being we are going to have to accept relatively low returns from our fixed income allocation in the portfolio.

The diversifiers or alternative strategies in a portfolio (Global Macro, CTA and Market Neutral) have underperformed against equities and struggled to outperform cash over the last 12-18 months as the equity bull market has endured.  The primary objective of these strategies is to make money in a bear market and hopefully outperform cash the rest of the time. This cycle, albeit disappointing for macro, market neutral and CTAs to date, hasn’t been significantly different than the previous ones. If a trade war escalates and emerging markets continue to deteriorate, the increase in volatility could create opportunities for them and we believe clients should maintain the exposure to alternatives as portfolio insurance for when the inevitable downturn eventually arrives.

So, in summary, we have a text book late cycle environment. Equities while looking expensive have outperformed and are likely to do so until the economy deteriorates. The diversifiers have underperformed, and the temptation is there to give up on them, but usually that is the time when they become most useful. We do not think this is the time to have extreme conviction in any asset class and diversification makes sense until valuations become more compelling.

 

Sources

• Perpetual Asset Management
• Ellerston Capital, Thought Piece (Glenn Stevens August 2018)
• Robeco Institutional Asset Management, 5 Year Expected Returns (September 2018)

Feature Image

Fernando @cferdo

 

Executive Summary

 

We held our quarterly Asset Allocation Investment committee in March. As part of the committee process we assess the macro economic environment, the strength of the business cycle, asset valuations and sentiment.

• We believe that the US economy and Global economy is firing on all cylinders and expect it to accelerate through 2018.
• The broadening of the US recovery to middle class households, in our view, can lead to several more years of growth in the United States, independent of policy change.
• We believe tax cuts in the US will lift corporate earnings substantially and add to momentum in markets and the economy this year.
• We now believe the FOMC may implement as many as four additional 25 bp rate hikes into 2019, taking the Fed Funds target rate to a range of 2.25%–2.50% within 12 months.
• The Australian economy is continuing to grow steadily, but below trend. Non-mining business investment remains solid and employment is steady, although we remain concerned about the lack of wage growth, and high private debt levels which make Australia vulnerable to a global rising cost of capital if it eventuates.
• We continue to watch the US 10-year treasury yield which has spiked from 2.0% in September, to 2.9% today. President Trump’s policy of increasing the deficit risks this risk-free rate blowing out further over the next 12 months.
• Our medium-term view on interest rates is there is now a rising risk of inflation accelerating to a point where Central Banks will need to tighten more aggressively than anticipated by markets. This could put pressure on asset valuations which have been priced assuming a low inflation, low interest rate regime is likely to prevail indefinitely.
• Our overall view on valuations has not changed materially. Asset prices continue to trade at fair to expensive ranges with the US market being one of the more expensive markets and Australia, only slightly above fair value. If the discount rate moves materially higher in quick time due to rising interest rates valuations face the risk of further corrections as experienced in February.

While in previous updates we have devoted much time to presenting an update on the status of the global economy, our intention in this update is to spend less time on the current state of the economy and devote more time to the outlook. This is because we truly believe that we have arrived at a crossroads for Financial Markets and Asset prices.

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The Global Economy

This is probably the easiest Economic update we have written in a decade, because the good news is the global economy is now firing on all cylinders.

The US, eurozone and China are all likely to grow well above trend in 2018 and global economic growth is set to remain above 3% for three consecutive years until 2019, a performance not achieved since the mid-2000s. We expect global growth to accelerate in 2018, led by the US.

The acceleration in private investment, pro-cyclical US fiscal easing and global monetary policies that are still very loose are all boosting growth in the advanced economies, while higher commodity prices and the weakening of the US dollar have underpinned an emerging market recovery. China is gently touching the brakes but is still prioritising high growth in the near term.

Growth in advanced economies is benefitting from a strengthening investment cycle as business sentiment improves, external demand picks up and labour resources become increasingly scarce. Tax reforms in the US could also boost investment. The pick-up in bank lending in the eurozone is particularly helping small and medium-sized firms, which account for half of capex, but reduced economic and policy uncertainty and rising capacity utilisation rates are also supporting the investment outlook.

Consumer spending in advanced economies is benefitting from the ongoing tightening in labour markets. Global monetary policy settings remain highly accommodative and credit conditions very easy despite the recent increases in bond yields. US fiscal policy is being eased aggressively, with the federal deficit likely to rise to over 5% of GDP by 2019 from around 3.5% in 2017.

Strong growth and declining unemployment have increased inflation risks in the advanced economies but a sharp surge in inflation still seems unlikely. Nevertheless, diminishing spare capacity is cementing the move towards monetary policy normalisation.

Central banks are becoming less cautious about normalising monetary policy in the face of strong growth and diminishing spare capacity. Fitch ratings expect the Fed to raise rates no less than seven times before the end of next year. And while still sounding tentative, the ECB is clearly laying firm groundwork for phasing out QE completely later this year. Fitch also expect the BoE to raise rates by 25bp this year.

We expect China’s economy to slow in 2018 as credit growth decelerates, housing sales flatten off and investment growth eases. Macro-prudential tightening has been a bit more concerted than expected but the authorities have recently reaffirmed their commitment to maintaining high growth rates in the short term. The wider emerging-market recovery has been helped by a weaker dollar and rising commodity prices, but these benefits are likely to fade as the US dollar should be supported by faster Fed rate rises and improving US growth prospects.

The IMF has upgraded growth forecasts as the eurozone recovery powers ahead, US fiscal policy easing by more than anticipated and investment prospects improve. US growth has been revised up to 2.7% in 2018 and 2.5% in 2019 from 2.5% and 2.2%, respectively. As we explain in our outlook, we believe this may well prove to be understated. Eurozone growth has been revised up to 2.5% in 2018 and 1.8% in 2019 from 2.2% and 1.7%, respectively. China’s 2018 forecast has also been revised up slightly (by 0.1pp) but growth is still expected to slow to 6.5% from 6.9% in 2017. Growth forecasts for Japan and the UK are unchanged for 2018 at 1.3% and 1.4%, respectively. We again see upside risk to Japan’s forecast.

As we stand today, things are looking good, and likely to get stronger. But what does that strength mean for investors who have become addicted to ultra-low interest rates? The key risk we see moving forward is a sharp pick-up in US core inflation – which would necessitate more abrupt, growth-negative adjustments in interest rates – and a major escalation in global trade protectionism. US-China trade tensions seem highly likely to increase in coming months, but the situation would have to deteriorate quite dramatically to adversely affect the near-term global growth outlook.

I haven’t mentioned Australia, much as there is not much new to say. Its steady as she goes down under. Housing is slowing, and consumer spending is constrained due to high debt and low wages growth. A lessening drag from mining investment and stronger non-mining investment (both public and private) along with solid export growth are likely to keep the economy growing and see a pick-up in growth to between 2.5% and 3%. However, growth is likely to remain below Reserve Bank of Australia expectations for a pick up to 3.25% this year and next. As a result, and with wages growth and inflation likely to remain low for a while yet, we have pushed out the expected timing for the first RBA rate hike from late this year into next year. We don’t believe the RBA will be the biggest influence on the cost of capital moving forward. That is likely to come from offshore.

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The outlook…Trump Likely to be the Root Cause of the next US recession. But not for the reason you think…

For the last 9 years US, European and Japanese Central bankers kept the cash rate at zero and purchased treasury securities to lower interest rates out to 30 years. The mantra has been growth, growth, growth. And they have been pushing hard to achieve it. It finally looks like they have been succeeded.

The Fed has had the motor running at full steam for the first 7 years, and ¾ throttle for the last 2 years and the economy has responded. Not at a blistering pace, but a solid pace, averaging about 2% growth.

With monetary policy being a slow-moving beast, the Fed must adjust speed and direction early as there is a limit to how far they can push the economy. That limit is inflation. Inflation risk has not been forefront in the Fed’s mind convinced they have plenty of time to change direction before it becomes an issue.

So when will they brake? Many prominent Economists are will tell you it is certainly not yet, due to the modest growth experienced post the financial crisis. Rogoff and Reinhart’s brilliant book “This Time is Different” had a simple message. On average it takes an economy 7 years to return to normal after a balance sheet recession. Seven years was 2015.

Nonetheless, during this time the Fed has been persistently optimistic about the growth recovery. So, when they say they expect 3% growth, the collective response from the market was “we aren’t going to see it.”
But the world has returned to normal. Around the middle of 2016. Pretty much right on schedule for Rogoff and Reinhart.

It is time for the Fed to start easing back on the throttle. And so, they delivered 3 rate hikes in 2017. Indeed, the market never believed the Fed would deliver 3 rate hikes last year. After all, they promised the same in 2015 and 16. The chart below shows what the Fed projected for each year, and what the market was expecting, in the December FOMC meeting prior to year (with exception of 2019, which is forecast from Dec 2017 Fed projection).

Strangely, after the Fed finally delivered on their forecast in 2017, the market was still well under-pricing the Fed projection in 2018 and 2019. So what changed in 2017 for the Fed? The NAIRU2 gap. The unemployment rate moved decisively through their estimate of NAIRU in 2017.

Historically the Fed would have had cash rates about 1% above their estimate of neutral (which would be around 4% today) by the time the labour market was this strong. But given the scarring experience of the financial crisis, the Fed has decided to keep pumping the gas. So how much far have they been pumping? Well, try 3 years! They don’t forecast reaching a restrictive policy stance on interest rates until 3 years after breaching NAIRU…

So the Fed had planned to leave the tightening late, with the view that a steady pace of rate hikes now would slow the economy enough to limit further significant declines in the unemployment rate, and limit wage and inflation pressures.

This seemed to be working in 2017.

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Enter President Trump

But then along came Donald Trump. During 2017, the market gradually gave up on the expectation that the Republicans would be able to deliver tax cuts. Indeed, in November the probability assigned by the market for tax cuts to be delivered by the end of the year was just 20%. The Tax cuts were delivered December 22nd and US GDP forecasts for 2018 jumped by 0.4% to 2.7%.

This is very solid growth for a period when the Fed is trying to brake.

The Republicans entered 2018 again grappling with debt ceiling limits and threats of government shutdowns. And while no one is paying much attention, they reached an agreement to pass a Continuing Resolution on February 4th that allows for a $390 billion increase in spending over the next year ($330 billion on defence). We believe this additional spending could have the ability to add another 0.4% to GDP in 2018. The US may well grow above 3% this year!

What we have is the Fed trying to cool the US economy and the President trying to stimulate it. This size Fiscal stimulus from the government, with the economy fully employed, has simply never happened in peace time.

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What happens next?

The modestly good news is the new Federal Reserve Chair Jerome Powell knows he now must fight the White house.

“I think our view — my personal view — would be that there will be a meaningful increment to demand, at least for the next couple of years, from the combination of those two things” [tax cuts and continuing resolution], he said last month in front of Congress.

We believe we are going to see a Fed that is resolutely determined to get back to neutral as quickly and calmly as possible. So, we expect a Fed Funds rate hike every single quarter for the next 2 years. Isn’t that aggressive? No! The last hiking cycle in 2004-2006 was 8 hikes a year. And the Fed thought in hindsight that was too slow.

Will the Fed panic, and slam the breaks harder? It’s not impossible. What could that look like? In 1994 there were 300 points of rate hikes in 12 months. (See graph below)

Is that a reasonable comparison? In this cycle the Fed has left the braking late, much later than 1994, and there was no fiscal stimulus in 1994. The one comparison to 1994 was that growth sharply accelerated. Greenspan responded ferociously, and legendarily managed a slowdown rather than a recession. Equities finished the year flat.

This is the first time since the Great Depression that the Fed has been actively trying to lift inflation. So, it is the first time they have had monetary policy this loose when the economy is fully employed. Now many find it hard to imagine inflation ever developing. After all, we have cheap goods from Asia, and the internet ensuring people always find the cheapest price. There is simple no pricing power. Except input price measures globally are rising. And rising input prices in China leads to rising import prices in America.

And would you believe prices are rising on the internet in the US.

So, we have increasing input costs for goods. We have evidence of pricing power on the internet and we have the tightest labour market we have seen in 30 years, with a big acceleration in growth to come. We are now at the point when wages historically surge.

So, will wages growth breakout? Small business is telling us they plan to pay more….

While I have focussed much of this piece on the US, Europe and Japan are also experiencing a transition to faster growth and capacity constraints. See the chart below for labour shortages in Germany.

The evidence is also mounting in Japan……

You may think we are spending too much time worrying about something that may or may not happen and we should be more bullish in the current wonderful growth numbers and live for the day. The reason we worry is because if wages do break higher, the risk of the Fed over tightening and delivering a recession sky rocket.

• What would happen to bonds in this scenario? We will see serious capital losses.
• Interest rate sensitive assets such as real estate and infrastructure will be crushed.
• What will equity indices do in the next US recession? Historically, peak to trough, anywhere from down 20% to down 50%.
• Is that going to happen? Well, we think this all comes down to how high and how fast rates rise.

Assuming the current US growth continues, by the end of 2019, a “good” result would be a Fed cash rate of 3.5%, and a 10-year treasury bond of 3.75%. With that good result, equities should cope, with indices eking out 5-10% returns each year, and hopefully good active management can add some alpha above that, but with a lot more volatility than everyone is used to.

If equities are grinding higher and It is hard to envisage bond portfolio’s providing a positive return in a period interest rates are rising, a traditionally allocated balanced fund should generate a positive return, but only just.

Remember that is based on the “good” outcome of an orderly rise in rates.

If wages accelerate quickly to 4%, the Fed and asset markets have an almighty problem. Historically, the Fed would move aggressively to slow the economy and anchor inflation expectations. Historically, this typically resulted in a recession (the exception being 1994). It is very hard to slow an economy “just enough” hence the risk of overtightening.

We are not predicting inflation is returning to anything like the 1970’s, the point is only a slight pick-up in inflation could cause quite a lot of problems because, we have never seen asset markets more leveraged and invested in low inflation forever. Risk parity strategies so popular with the advent of algorithm trading will be toast in this environment. The combination of having to deleverage due to high volatility, and redemptions, could require as much as 1.5 trillion in bond sales from this group. Into a falling bond market.

So, should we worry?

We don’t think there will be problems in 2018, corporate earnings are very strong, defaults are low and there is fiscal stimulus on the horizon, so we wouldn’t be surprised if markets move to new highs above their February peaks in 2018. It is more likely markets will eventually be worn down by the cumulative tightening sometime in 2019 or 2020. But it is time to start preparing for a new environment, as we won’t pick the top of markets.

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Consequences for Asset Allocation and Portfolio Construction

While we think there is still a little left in the cycle, particularly for more conservative investors, it is a time to be prudent in bonds, equities, credit, REITs and infrastructure. Anything that has benefitted from low interest rates in the world. We could be seeing a structural, once-in-a-generation shift to inflation. This will require radically different thinking for most investors. Treasury bonds will no longer be good portfolio diversifiers.

We need to be aggressive on any investment that can benefit from rising interest rates. Commodities, Gold, Global Macro Strategies come to mind as diversifiers and getting your stocks and sectors right is going to be critical in equities. A Fed that has been well and truly testing the limit, now has a massive fiscal stimulus at exactly the wrong time. We expect them to hit the brakes hard and hope for the best.

It is likely the easy money has been made from this cycle and things are going to get a whole lot more volatile and difficult from here. Just don’t be fooled if growth picks up and the short-term market response is positive. This growth is what will cause the tightening.

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Sources:

• Fitch ratings, Global Economic Outlook (March 2018)
• Ellerston Capital, Breaking the Limit (Brett Gillespie March 2018)
• The Pain Report, Brace yourself for a global inflation shock (Jonathan Pain, February 2018)
• Gavcal, SIC Conference presentation (Louis Gave, March 2018)

Footnotes:

1. Growth in 2015/16 was hurt by the 20%+ appreciation in the USD in H2 14. And compounded by 60% fall in the oil price in H2 14 as well, which led to a capex collapse in shale in 2015. Without these two exogenous events, the US recovery would have begun in earnest in 2015 right on Rogoff cue
2. NAIRU is an acronym for non-accelerating inflation rate of unemployment and refers to a level of unemployment below which inflation rises.

Featured Image:

Mikito Tateisi

Executive Summary

We held our quarterly Asset Allocation Investment committee in October. As part of the committee process we assess the macro economic environment, the strength of the business cycle, asset valuations and sentiment.

• The overall economic environment continues to show signs of improvement, economic indicators such as PMIs continued to rise in key economies such as the US, Europe and Japan.
• The US economy is in better shape than commonly appreciated and the global economic environment is more supportive than it has been for quite some time.
• Stronger growth in the United States and globally has been good for equity and credit markets. We believe it can continue over the short-to-medium term.
• In Australia non-mining business investment remains strong and employment is steady, although we remain concerned about the lack of wage growth, which unless shows signs of improving, will be a drag on consumer confidence.
• We continue to watch how central banks approach their monetary policies settings as we see central banks gradually reduce their quantitative easing (QE) programs and subsequently reduce the size of their balance sheets.
• Our medium-term view on interest rates is that rates will increase from their current low levels however we do not expect rates to rise rapidly in the short term which will continue to be constructive for equity markets.
• Our overall view on valuations has not changed materially. Asset prices continue to trade at fair to expensive ranges with the US market being one of the more expensive markets and Australia, only slightly above fair value.
• US tax reform should be a catalyst for improved US earnings and short-term market optimism.

Since our most recent update in March, the overall economic environment continues to show signs of improvement, economic indicators such as PMIs continued to rise in key economies such as the US, Europe and Japan. In a sign of increased optimism, the IMF upgraded its growth forecasts for the first time in six years. The US and Europe currently lead the way, although China and Japan have generally exceeded expectations. While inflation continues to surprise to the downside, the improved growth picture has turned the focus on to the central banks, with the Fed in the early stages of monetary policy normalisation, and the ECB soon to follow.

In Australia non-mining business investment remains strong and employment is steady, although the lack of wage growth has been a drag on consumer confidence. We continue to monitor how central banks approach their monetary policies settings as we see central banks gradually reduce their quantitative easing (QE) programs, and subsequently reduce the size of their balance sheets. The rapid increase in liquidity into markets as a result of QE provided a significant boost to equity markets therefore central backs will need to manage the ‘normalisation’ of their monetary policy carefully as we believe a rapid pull back in liquidity would be negative for markets. Our medium-term view on interest rates is that rates will increase from their current low levels, and we expect 2018 to be the first time since November 2010 when the RBA has raised interest rates.

Our view is that while clearly, we are late cycle in the economic and market expansion led by the US since the GFC, the resilience of financial markets over 2017, particularly from offshore, leads us to believe there is another leg up for financial markets before the end of the current cycle. This does not change the view that asset prices are expensive. Valuations look extremely stretched by historical standards, however that does not mean that they can’t become more stretched before the current cycle ends.

The ASX 200, does not appear as overvalued as US equities. The ASX200 has hardly risen this year and is trading on a price-earnings ratio of just below 16x which is only marginally above the long-term average of around 15x.

Figure 1 Australia S&P/ASX PE ratio

 

The US, on the other hand, has seen the S&P 500 up 12.5% this year, the NASDAQ up 20.5% and the S&P 500 has moved from a price-earnings ratio of 18x to 23x in the last 2 years. That means that US share prices have risen 27% more than earnings since early 2015. Clearly that is not sustainable over the long term.

 

Figure 2 S&P 500 PE ratio

 

Despite all the fundamental factors which have caused us to take a view we are very late in the current expansion cycle (e.g. lending standards deteriorating, and the Fed’s commencement of interest rate rises) the US market looks like it is still accelerating, and it appears this cycle will not end without valuations looking absolutely bubble like as occurred in 1987, 2000 and 2007. We believe US tax cuts which could be implemented in late 2017 or early 2018 will provide the catalyst for the last leg up in the US markets.  Historically, the best returns in a cycle are the very early part, as the market recovers from an oversold position (think 2009-2010) and the very late part, as overvaluation sets in and market participants using fundamental valuation analysis begin making bubble calls on the market. They are usually right, but often a year or two too early.

 

United States 

The global synchronized recovery has strengthened. The US economy has rebounded from a weak first quarter; growth in the euro zone remains robust and broad; Japan has now experienced six consecutive quarters of growth, its longest expansion in over a decade; and growth in China continues to exceed the government’s target. Of the 43 major economies tracked by the OECD that have reported second-quarter real GDP, just Iceland had negative GDP growth.

The positive economic data has been good for equity and credit markets, lifting both earnings and earnings forecasts (See table below). We expect that this constructive environment—improved growth, low inflation, and relatively loose financial conditions—will continue over the short-to-medium term. Looking forward, we see geopolitical tensions (particularly in North Korea), the risk of monetary policy mistakes, a failure to raise the debt ceiling, and potential protectionist measures as the biggest risks to our outlook and to market sentiment.

 

Figure 3 The global synchronized recovery is lifting earnings estimates

As of 31 August 2017
Source: Bloomberg, MSCI

 

Second-quarter real US GDP rebounded from a weak first quarter, rising by 3.1% at an annual rate. Final sales to private domestic purchasers—the components of GDP that make up private domestic demand—were even stronger, rising by 3.3% at an annual rate. Particularly encouraging has been the rebound in business investment, which has risen by an annualized 6.9% in the first two quarters of the year, helped in part by stable energy prices. However, retail sales and industrial production slowed in August, moderating expectations for third-quarter growth. As a result, the New York Fed’s third-quarter Nowcast and the Atlanta Fed’s third-quarter GDPNow forecast declined considerably, and stand at 1.5% and 2.1% respectively.

Two devastating hurricanes hit the Gulf Coast and the Southeast, as well as a number of Caribbean islands. Outside of their considerable human costs, the damage and recovery will have economic implications. The short-term impact has been to increase headline inflation due to higher gasoline costs and to disrupt income and economic activity, which will affect GDP growth, employment, and many other economic indicators. Over the medium term, we expect the national economic trajectory to return to the trend before the hurricanes, although local metrics will continue to reflect rebuilding.

We continue to be encouraged by data suggesting that middle class income is increasing more solidly after stagnating since the turn of the century. Newly released data shows that real median household income rose 3.2% in 2016, the second-largest gain since 1998 after 2015’s record-setting 5.2% gain, capping the largest two-year increase in the data series’ 50-year history (See table below). While not quite as strong and as broad as in 2015, the details of the release also were positive, showing that real income rose for most household groups-regardless of age, income, race/ethnicity, education, and region. More recent trends in wages and employment imply that middle class household income has continued to rise in 2017, which should be positive for consumption and the economy. It is no accident that these developments have come in a tightening labour market.

 

Figure 4 2015–2016 Was the Largest Two-Year Increase in Real Median Household Income since 1967

As of 30 September 2017
Source: Census Bureau, Haver Analytics

 

The Federal Open Market Committee (FOMC) announced that the Fed will begin to reduce the size of its balance sheet, beginning in October by allowing $6 billion of Treasuries and $4 billion of mortgage-backed securities to mature without reinvesting the principal. Despite understandable concerns that unwinding quantitative easing (QE) will have unforeseen consequences, we believe its impact on rates and markets will be small.

In the latest Summary of Economic Projections (SEP), the FOMC also indicated that the meeting participants still anticipate an additional rate hike in 2017 and three rate hikes in 2018.

Inflation has decelerated since the beginning of the year. New “transitory factors” have contributed, especially sharply lower prices for wireless plans. However, the inflation weakness has been broad enough, and inflation has fallen short of the Fed’s target (and projections) for long enough, that there are fresh concerns about inflation’s fundamental drivers. These were discussed by Fed Governor Lael Brainard in a recent speech: “in today’s economy, there are reasons to worry that the Phillips curve will not prove very reliable in boosting inflation as resource utilization tightens.”3 Our view remains that with continued growth, inflation should rise to a 2%–3% range (as measured by the Consumer Price Index (CPI)). Regardless, the implication of recent trends for markets is that inflation should be controllable and that the Fed’s hiking cycle will be gradual and short—a view currently priced in fed funds futures but not in the Fed’s projections of future rate hikes.

The upcoming 2018 mid-term elections leave a short timeline for the congressional GOP legislative agenda, making economists relatively pessimistic about the near-term prospects for tax reform and an infrastructure package. Some hopes for bipartisan cooperation on these issues, and on health care, emerged with the deal between President Donald Trump and Congressional Democrats on hurricane relief. We remain concerned that a Congressional vote to increase the debt ceiling—now pushed back to December or possibly to the first quarter—will become contentious, which we think is more likely to disrupt markets than will the Fed’s balance sheet policies. We also believe meaningful risks remain that protectionist policies could surface on the White House agenda, particularly if cooperation with Congress becomes difficult.

Through much of the recovery since 2009, wage gains have been surprisingly low. A variety of factors contributed to this disappointing wage rebound:

• the severity of the global financial crisis, which saw the headline unemployment rate hit 10.0%;
• “pent-up wage deflation” as wage growth slowed less than expected during the crisis; and
• “hidden slack” in the form of people working part time who wanted full-time work, people who took jobs for which they were overqualified, and people who withdrew from the labour force.

In 2013, wage growth began to grind higher, but more recently it appears to have plateaued across several measures. This stabilisation has caused understandable concerns, given that it has coincided with a slowdown in inflation more generally. However, we believe this plateau is temporary and expect wage growth to accelerate again.

Figure 5 Wage Growth Recently Plateaued

As of June 2017. Avg. hourly earnings and Atlanta Federal Wage Growth Tracker as of August 2017.
Average Hourly Earnings are for all employees. Employment Cost Index (ECI) is for wages & salaries of civilian workers excluding incentive-paid occupations. The ECI is a disaggregated quarterly series. The Atlanta Federal Wage Growth Tracker is adjusted downwards by 0.6 percentage points to reflect its historical spread with other wage measures.
Source: Bureau of Labour Statistics, Federal Reserve Bank of Atlanta, Haver Analytics

 

We believe the recent plateau in wage growth reflects two different mix shifts in the labour market, the impacts of which have been enlarged by the severity of the crisis and the length of the recovery. One mix shift is related to the jobs being filled and another is related to who is filling them:

The first mix shift relates to the positions being filled. Early in the recovery, employers had substantial bargaining power and could hire overqualified people to part-time jobs, e.g., the college-educated barista at Starbucks. As the recovery has progressed, an increasing number of employees have been able to improve their circumstances, graduating to better jobs, and moving from part-time work to full-time work, from unemployment to employment, and from discouraged and out of the workforce to back into labour force participation. As this shift has taken place, it has put downward pressure on wage growth as “new” employees command lower full-time wages than those with recent experience in similar jobs. In fact, in a 2014 speech, Janet Yellen described how this mix shift might translate to the recent pattern of wage growth: “profound dislocations in the labour market in recent years—such as depressed participation associated with worker discouragement and a still-substantial level of long-term unemployment—may cause inflation pressures to arise earlier than usual as the degree of slack in the labour market declines.

However, some of the resulting wage and price pressures could subsequently ease as higher real wages draw workers back into the labour force and lower long-term unemployment.” The Graph below isolates the impact of this mix shift on wages by showing that earnings growth for individuals already in full-time employment has been much stronger than the median, which has been dragged down by the impact of flows into and out of full-time employment by part-timers, the unemployed, and people outside of the labour force. The critical point is that the impact of this mix shift should fade over time.

 

Figure 6 Aggregate Wage Growth Has Been Held Down by Flows into Full-Time Work

As of 30 June 2017,
Source: Daly, Mary C., Bart Hobijn, and Benjamin Pyle. 14 August 2017. “The Good News on Wage Growth.” Federal Reserve Bank of San Francisco Blog

 

The second mix shift could reflect the demographic profile of the applicants for jobs. Since 2015, the employment-population ratio, which captures net flows into employment of the unemployed and of people outside of the workforce, has risen by three times as much for prime-age (25–54) women as for prime-age men and nine times as much for African Americans as for whites. Similarly, it has risen by 1.7 percentage points for people without a high school degree and fallen by 0.4 percentage points for college graduates.9 To the extent the faster-growing portions of the labour market have historically been paid lower wages, we believe this could also lead to lower wage growth in aggregate. Shifting demographics may exert a similar generational impact on wage growth over the medium term, as retiring baby boomers are replaced in the workforce by millennials.

As these mix shift effects dissipate, we would expect wage growth to more closely resemble the historical relationship seen before the global financial crisis. In short, we think the recent pullback in wage growth acceleration is still consistent with a healthy labour market and income growth more generally. To the extent this is the case, and more people are able to enter better, and higher-paying, employment, it should be positive for the economy.

Looking forward, we expect this plateau in wage growth to be relatively short-lived. Demand for labour remains strong, with job openings at record highs and most surveys of employers reporting difficulty filling jobs. Our view is that employers will eventually come to grips with the need to pay higher wages if they wish to fill open positions and attract qualified candidates. At the same time, we believe the synchronized global economic recovery should also add confidence in completing hiring plans, where in the past, employers might have been reluctant to commit to adding to full-time staff.

While he attempts to overhaul American tax, trade, and immigration policies, President Donald Trump is mulling over a set of decisions that could prove even more consequential for the U.S. economy. With Federal Reserve Vice Chair Stanley Fischer having retired this month, three of the seven seats on the Fed Board of Governors are now vacant. And in February 2018, Fed Chair Janet Yellen’s first term will end, giving Trump a unique opportunity to stamp his brand on the institution.

Trump’s nominees to fill these positions, and how he goes about choosing them, could have an enduring impact not just on the Fed, but also on the U.S. economy and its central position in the global financial system.

The Favorites to lead the Fed are Jay Powell and John Taylor. Powell is assumed to be a candidate that is seen to favour the status quo of the current board, while Taylor is expected to be in favour of more aggressive tightening of monetary policy. Whom is appointed, and their policy stance will likely play a major role in determining the length of the current expansion.

 

China

The Chinese Communist Party (CCP) held its 19th Party Congress in Beijing from October 18–25, 2017, a twice-per-decade event to set the party’s national policy goals and elect its top leadership. Although observers eagerly awaited the conclusion of the First Plenum of the 19th Central Committee on October 25, when the new members of the CCP’s all-powerful Politburo Standing Committee were unveiled, the weeks leading up to that moment were also rich with important developments. Likewise, the influence of China’s new leadership team on the direction of the country’s foreign and domestic policy will gradually play out over the coming months and years.

October’s Party Congress is part of a series of decision-making events over the next six months. The government’s working plan for 2018, including economic policies, will be presented at the National People’s Congress in March, where the new cabinet also will be appointed. While the challenges facing the Chinese economy are acknowledged by its leadership, addressing them is immensely complicated. The incentive to maintain relatively high growth is still strong, especially since real growth of 6.5% per year is still necessary to achieve the target of doubling 2010 GDP and per capita income by 2020, ahead of the CCP’s 100th anniversary in 2021.

Like many, we think a smooth deceleration in growth in China is overdue and would be a positive outcome. Our concern over the medium term is that it is not clear that any leader can “engineer” the necessary rebalancing of the economy and deceleration of growth, even setting aside political and institutional constraints and incentives. However, contained its financial system, we worry that China’s massive build-up of leverage in recent years, much of it hidden and hard to understand, as well as the rapid shifts in directions of its capital flows, could trigger a future global economic slowdown or even crisis.

 

Europe

European stock performance has been relatively muted in recent months, due mostly to the resurgence of the euro. While some commentators have cited the strength of the euro as a cause for concern, we regard it as a testament to Europe’s ongoing economic recovery.

The performance of the Stoxx Europe 600 Index has been impressive, in our view, considering the euro’s strength. While the index rose 1.8% in local currency terms over the last two quarters, the euro has appreciated a staggering 10.9% against the US dollar over the same period. A significant proportion of companies listed in Europe derive their earnings from overseas markets (44%), particularly from the United States (18%), so this currency story—and the positive return generated by European markets in spite of it—is consequential. When adjusting for the euro’s appreciation, the trajectory of European equities has been markedly different, outperforming both the US and global stock markets.

 

Figure 7 European Stocks Outshine US and Global Indices in US Dollar Terms

September 2017
Source: FTSE, Standard & Poor’s, STOXX

 

In our view, the stronger euro has been a reflection of the improving economic backdrop and political sentiment in Europe, rather than the repricing of monetary policy expectations. Investor expectations of an interest rate hike in Europe by the end of next year have fallen to the lowest on record, according to futures markets. Investors are pricing in a less than 50% chance that the European Central Bank (ECB) will lift interest rates in 2018, despite the central bank laying the groundwork for a decision on winding down its asset-purchasing programme.

The ECB is treading carefully as it attempts to normalise monetary policy in a balanced way that brings inflation to just under 2% over the medium term, in line with its target, without compromising the momentum in economic growth. The ECB has scope to remain accommodative as the Harmonised Index of Consumer Prices—the ECB’s preferred measure—currently stands at 1.5%. Despite inflation’s short-lived foray between 1.5% and 2.0% from January through April, consumer prices have yet to show convincing signs of a sustained upward trend, a key requirement for the ECB to withdraw its ultra-loose monetary policy. At the same time, the stronger euro also effectively implies a tightening of financial conditions and further disinflationary pressure, if sustained, as it pushes down import costs. The ECB has trimmed its medium-term inflation forecasts, despite acknowledging the strength of the euro zone’s economic recovery. Since the start of the year, the ECB has revised lower its inflation forecasts for 2018 from 1.5% to 1.3% and then to 1.2% in its September staff macroeconomic projections. For 2019, its inflation forecasts were lowered from 1.8% to 1.6% and then, most recently, to 1.5%.

At the same time, economic growth in the euro zone has continued to surprise to the upside, as unemployment has trended lower into single digits. In September, the ECB raised its 2017 economic growth forecast for the euro zone to 2.2%, putting it on track for the strongest growth in 10 years. In a sign of growing confidence in the euro zone’s recovery since the doldrums of the European sovereign debt crisis, Standard & Poor’s restored Portugal’s government debt rating to “investment grade” status after holding it at “junk” for five years. At the height of the crisis, the yield on Portugal’s benchmark 10-year bond rose above 16%, but as of September 2017 it stands at around 2.5%. Equally, other formerly “frail” economies have been on an upward trajectory. Spain has been growing above trend and in excess of euro area averages since 2014.

While some economists have voiced concerns about the strength of the euro and its potential impact on export-led growth, the euro zone recovery has, in recent years, increasingly been driven by domestic demand relative to net exports. If we are entering a new era of euro strength that is structural in nature, there are reasons to remain constructive on the outlook for European stocks, as a stronger euro has in the past often coincided with stronger European stock markets.

 

Figure 8 Euro Strength Has Coincided with European Equity Outperformance

As of 30 September 2017
Source: MSCI

 

Much of the election uncertainty that dominated sentiment earlier this year has passed, offering a supportive backdrop for investors. Elections in the Netherlands and France earlier this year yielded market-friendly outcomes, while in Germany, Chancellor Angela Merkel secured a fourth term in office. While the gains for the far-right party Alternative für Deutschland in the German election came as a surprise—making the party the first openly nationalist partly to reside in parliament in almost 60 years—and will likely change the tone of the Bundestag, we do not anticipate coalition talks to be materially impacted by their presence in parliament.

We would argue that Italy and Spain—given Catalonia’s ongoing campaign for independence—remain flash points of political risk in Europe, albeit relatively contained.

Overall, we think the outlook for European stocks remains constructive owing to the continued positive momentum in economic growth and subdued inflation profile, which suggests the ECB has scope to remain accommodative for longer. Political sentiment has improved materially since the start of the year and while Italy and Spain remain flash points of political risk in Europe, longer term, it is our belief that company fundamentals will play out and assert themselves, irrespective of political noise. Furthermore, the European stock market remains attractive versus other markets, such as the United States, on a valuation basis.

 

The United Kingdom

The medium-term growth outlook for the UK remains highly uncertain and will depend in part on the new economic relationship with the EU and the extent of the increase in barriers to trade, migration, and cross-border financial activity. GDP rose 0.4% in the last three months, beating the 0.3% estimates. Services rose 0.4%; industrial production jumped 1% while construction shrank the most in five years. The UK’s comparatively tepid growth in the last 12 months has left it the odd one out in the global upswing.

While the IMF raised its forecasts for almost every advanced economy the month, the UK outlook was left unchanged at 1.7% this year and 1.5% in 2018. The IMF predicts it will grow at just half the global average. With inflation at the fastest in more than five years, Governor Mark Carney has said tightening may be needed within months, and economists and traders expect the bank to increase borrowing costs on November 2. Even though the latest quarter was better than expected, growth is still running at a weaker pace than it was in 2016. The pace is also slower than when the BOE has raised interest rates in the past.

Some have warned that a hike could be a policy mistake given the UK’s relatively sluggish growth and Brexit-related uncertainty that’s clouding the outlook. They also argue that inflation is being driven by the weaker pound, rather than being domestically generated.

But in Carney’s assessment, Brexit has crimped UK potential growth, lowering the level of expansion the economy can take without overheating.

We remain cautious on the UK until further clarity on the terms and conditions of Brexit become known and prefer the opportunities provided by continental Europe at present.

 

Japan

Japan’s economy expanded by an annualized rate of 4% during the June quarter, beating market expectations and outpacing most other developed economies. Wage gains and consumption were two of the biggest contributors to this GDP growth. While a late revision to capital expenditures (capex) led to a downward revision of GDP, the general trend of positive demand driving higher production remained in place. Moreover, improvements in global purchasing managers’ indices (PMI) helped boost Japan’s manufacturing sector as investors anticipated better demand and pricing to positively influence profits for the coming fiscal year. During the quarter, corporate profits rose by 21% over the previous year, providing a much-needed lift to both the earnings outlook and equity valuations.

Positive economic data continues to compound in Japan. Domestic and global PMIs suggest improvements in production and the potential for upward surprises to economic growth. Historically, Japan’s market has had a high correlation with global PMIs, so this shift to the upside should be a welcome surprise. Many investors think that the end to the growth cycle is near, but we believe both macro and micro data continue to suggest that demand and pricing of everything from steel to chemicals to semiconductor equipment is improving. Since these areas are traditional strengths for Japanese manufacturers, this trend should help sentiment regarding profits and valuations in what many consider richly priced segments of the market.

 

Figure 9 Global Purchasing Manager Indices Are Strong and Improving

As of 31 August 2017
Source: Markit, Nikkei

 

From a geopolitical perspective, the ongoing issues with North Korea have presented Prime Minister Shinzo Abe with an array of problems. As long as the North Korean government continues to ignore convention and test launch more intercontinental ballistic missiles, Japan faces a real test of its military mettle. There is a significant risk that Japan, or a similarly minded ally, chooses to shoot down one of these missiles. This could spark a military clash with North Korea. As long as this conflict lasts, it is important to monitor how Abe is perceived and how the market reacts. If anything, the recent rise in Abe’s popularity points to a potential improvement in sentiment as he is seen as one of the few Japanese leaders with the ability to stand up to a military rival.

Regardless of general market sentiment, it appears that better growth and an improvement in pricing are closely associated. As long as the United States continues down this quantitative tightening path, we believe the Japanese market will follow. Financial stocks, which have rarely provided upside surprises in the past, now look attractive from a relative value perspective. Therefore, we believe there is significant upside potential for cyclical sectors, like financials which have long been ignored, and for the Japanese market as a whole.

 

Australia

After a soft patch in the March quarter, Australian economic growth bounced back in the June quarter with quarterly growth of 0.8%, up from 0.3%. However, annual growth is still subdued at 1.8% year on year, which is well below potential of around 2.75%. In the quarter, growth was helped by a pick-up in consumer spending and business investment, strong public investment and a contribution from net exports after a detraction in the March quarter.

 

Figure 10 Australian Real GDP Growth

Source: ABS, AMP Capital

 

Australia continues to defy the doomsters’ endless recession calls. Against this, economic and underlying profit growth is lagging that seen in major economies. However, there are some positives pointing to a pick-up in growth.

Putting global threats aside, Australia’s worry list is well known:

• Housing construction is starting to slow with falling approvals pointing to a further slowing.
• Consumer spending is constrained by record low wages growth and high levels of underemployment. While consumer spending has been running faster than income growth, as rising wealth has allowed consumers to run down household savings (to now just 4.6%) this is unlikely to continue as the wealth effects flowing from property price gains in Sydney and Melbourne slow. Rapid power cost increases and high debt are also not helping. All of which is driving low consumer confidence.
• Mining investment is still falling with business investment intentions pointing to another 22% fall this financial year.
• The Australian dollar is up 14% from last year’s low and at around $US0.78 it is at risk of slowing growth and investment in trade-exposed sectors like tourism, agriculture and manufacturing.
• Underlying inflation is too low and risks staying below target for longer due to record low wages growth, a rising $A, competitive pressures & weak rents as new supply hits.
• Our political leaders seem collectively unable to undertake productivity-enhancing economic reforms and take decisive action (eg, on energy policy). With the citizenship crisis threatening an early election, it’s unlikely we will see an improvement any time soon.

 

Figure 11 Falling building approvals

Source: ABS, AMP Capital

 

These worries are well known and despite them we remain of the view that recession will be avoided and growth will pick up over the year ahead. First, the growth drag from falling mining investment is nearly over. Mining investment peaked at nearly 7% of GDP four years ago and has since been falling at around 25% per annum (pa), knocking around 1.5% pa from GDP growth. At around 2% of GDP now, its weight in the economy has collapsed reducing its growth drag to around 0.4% this year and it appears near a bottom.

 

Figure 12 Mining investment as % of GDP

Source: ABS, AMP Capital

 

Non-mining investment is likely to rise this year. Comparing corporate investment plans for this financial year with those made a year ago points to a decline in business investment this year of around 3.5% (see next chart). But this is the best it’s been since 2013 and once mining investment is excluded this turns into an 8% gain for non-mining investment.

 

Figure 13 Actual and expected capital expenditure

Source: ABS, AMP Capital

 

Public investment is rising strongly, up 14.7% over the last year, reflecting state infrastructure spending. Net exports are also likely to continue adding to growth as the completion of resources projects boosts mining and energy export volumes and services sectors like tourism and higher education remain strong.

Finally, profits for listed companies are rising again after two years of falls. This is a positive for investment and the flow of dividends helps household incomes.

 

Figure 14 Australian Share market EPS growth

Source: ABS, AMP Capital

 

These considerations should ensure that the Australian economy continues to avoid recession and that growth should pick up to around a 2.5% to 3% pace over the year ahead. This should be enough to head off further cuts in the cash rate. But with growth still a bit below RBA forecasts, wages growth likely to pick up only slowly, inflation likely to remain subdued abstracting from higher electricity prices, and the RBA likely wanting to avoid pushing the $A higher, our view remains that the RBA will keep the cash rate unchanged at 1.5% out to at least the middle of 2018 before starting to raise rates.

 

Conclusion

In conclusion, there is reason to be generally optimistic in terms of the global growth outlook and financial markets for the remainder of 2017 and early into 2018. Global growth is accelerating, and any positive outcomes on tax reform, could provide the catalyst to another leg up in financial markets. Our fears that faster growth would spark inflation and force central banks hands to tighten financial conditions and complete the cycle have not yet materialised and we are currently in a goldilocks environment – that is growth in the world economy, but not with too much inflation.

 

Figure 15 Goldilocks – above trend growth and below trend inflation

Source: BofA Merrill Lynch Global Fund Manager Survey

 

The environment for equities is positive, barring unforeseen geopolitical and policy shocks, on the back of potentially positive tax policy changes and low global interest rates. While there are some very real risks in the global economy, we believe the positive momentum can endure, at least until the middle of 2018.

 

Consequences for Asset Allocation and Portfolio Construction

Conditions appear to be favourable for equity markets in the short term as the current cycle plays out. As it appears markets want to continue to head higher, we want to ensure our equity and fund manager exposure in the growth asset portion of investors portfolio’s will capture as much of the upside as possible as a potential bubble forms in equity markets in the next 6-12 months. While we are cautious holding financial assets that are beginning to look overvalued, we don’t fear the onset of an equity bubble. We think it is very unlikely for the trend to change until after US tax reform has been implemented, as tax cuts are likely to improve corporate earnings again next year. So, if we do get a fully blown equity bubble of the back of that enthusiasm, we intend to take advantage of it.

This short term bullish tilt, does not mean we believe investors should be ‘all in’ on risk assets. We also want to have hedges and diversity in the portfolio this late in the cycle, as correctly calling the peak, or end of the cycle is almost impossible. There is also always the risk of a left field event or the breakdown in the US political process grinding reform to a halt, so ensuring you maintain diversification in line with your individual risk profile remains critical.

We outline our approach below for the present environment:

Approach To develop a clear diversified investment strategy with an outcomes based asset allocation to ensure relevant cash flow is produced in a tax efficient manner	Strategy Moderate but accelerating economic growth with a solid employment picture should underpin outperformance by the US and other developed markets. We see the U.S. dollar as likely to strengthen against the $AUD and most other major currencies. We view this as a cyclical upswing rather than a secular or structural shift. Longer term we expect lower economic growth and lower natural interest rates due to demographics and debt levels. Risks continue to lie in China and the UK where caution is warranted	Themes We remain in a very low but rising interest rate world. Sustainable equity income strategies should still provide decent long term returns for patient investors. Investors hoping beta (the market) will provide longer term gains beyond the current cyclical Trump reflation are likely to be disappointed, so active strategies sourcing non correlated returns appear attractive. We believe American and European Consumers will benefit from oil price declines and boost spending.	Ideas
Capital Preservation Assets which have a high probability of retaining their capital value to provide defence when growth assets fall.	Increase exposure to: At call cash Term Deposits Very short Duration bonds Reduce exposure to: Fixed rate bonds for medium to long durations Government Bonds	Bond yields have begun to rise as expectations for deflation wane and inflation begins to rise. With elevated yields there is a risk of capital loss on long duration low coupon instruments.	Increasing cash holdings and Term Deposits.
Stable cash flows Assets where income streams are regular, steady and rising rather than focussing on capital growth	Increase exposure to: Growing dividend streams form Australian and International equities Senior Debt Reduce exposure to: High yield Debt (junk bonds) Leveraged Property	Equity and credit income strategies with a focus on dividend growth should remain in favour and preserve capital over the long run. Leveraged property and Infrastructure assets are likely to hit headwinds as interest rates rise.	Payden Income Opportunities Fund Henderson Tactical Income Fund Pimco Diversified Fixed Income Fund Investors Mutual Equity Income Fund
Equity Market Direction Exposure to equity markets domestically or globally for both income and growth	Increase exposure to: Active strategies where stock picking drives longer term return outcomes. Indices such as S&P500	Traditional market cap weighted passive strategies cannot protect on the downside. However, in the short term, the Trump reflation trade is likely to lift indices over a 12- 18 month timeframe.	Magellan Global Fund Platinum Japan Fund Allan Gray Australian Equity Fund Spheria Microcap Fund
Active Growth Access to opportunities or skills which have potential to produce better returns than holding investments passively. Higher returns may be delivered by skilful risk management and protection of capital in falling markets	Increase exposure to: Australian manager’s that tilt away from top 20 stocks Stock pickers who can hold more cash Long short strategies S&P 500, technology and Financials in the US	We favour strategies with flexible mandates with the ability to raise cash and use shorting to protect capital.	The Montgomery Fund L1 Capital Long Short Antipodes Global Fund VGI Partners Global Long Short
Diversifiers Investment strategies designed to produce returns which are lowly correlated to the direction of equity or fixed income markets	Increase exposure to: Market Neutral Strategies $USD Reduce exposure to: Commodities	Greater divergence in stock market returns should benefit market neutral managers. With our exposure to China and the Asian region a hedge by holding some $USD continues to make sense.	Watermark Market Neutral Fund   Winton Global Alpha Fund   Invesco Targeted Returns Fund

 

Sources:
October 2017 Global Outlook, Ronald Temple, Lazard Asset Management (October 2017)
Income & Fixed Interest Newsletter, Vimal Gor, BT Investment Management (October 2017)
Where are we in the global investment cycle and what’s the risk of a 1987 style crash? , Shane Oliver, AMP Capital (October 2017)
Bloomberg (October 2017)
ANZ Bank (October 2017)
Bank of America/ Merill Lynch (October 2017)
PIMCO (October 2017)

Executive Summary

 

• The biggest event for global financial markets in 2017 is likely to have already taken place on 20 January – when Donald Trump was sworn in as the 45th President of the United States.
• How the Trump Presidency unfolds will clearly have a significant impact not just on the US, but on global markets in 2017 and beyond.
• In terms of the global economic outlook for the remainder of 2017 – the US is also likely to dominate. A large scale US fiscal policy easing is expected to support growth, so global economic growth in the year ahead should be a little faster than recent years. This is likely to see global growth in 2017 close to 3.5%, from nearer 3% in 2016.
• The big question is, will the pace of trend GDP growth in the US be raised permanently by Trump’s policies and outstrip the cost of higher US debt and the rising cost of capital. If so, then the rally being enjoyed by ‘risk’ assets will become more entrenched. If not, then we are in for a multi-year ‘boom-bust’ cycle. We see more risk of this eventuating in 2018 or 2019. While Trumps policies are likely to extend the economic cycle by a year or two, we do not believe we are at the foot of a multi-year bull market and expansion.
• The main focus for this year is likely to be a trend to higher headline inflation, given the recent increase in key commodity prices – especially oil. Deflationary fears appear to have subsided since the change in US policy settings.
• Global monetary policy settings are unlikely to be eased further in 2017. We expect further tightening/normalisation of monetary policy in the US and no change in monetary policy by the other major central banks in 2017 (ECB, BoJ and BoE). The RBA and RBNZ are also expected to be on hold in 2017.
• Any fiscal policy easing in the US is expected to lead to further monetary policy tightening. This trend may also become evident elsewhere, especially in the UK and Japan.
• Key risks remain in Europe, especially around political and policy developments such as The French Presidential election (April-May), the German general election (likely September-October), political uncertainties in Italy and the start of Brexit negotiations in the UK.
• Concerns about a sharp slow-down in the pace of growth in China proved (once again) to be unfounded in 2016. Government investment spending and a depreciating currency both helped China grow by an estimated 6.7% last year.
• For 2017, slower Chinese growth expectations still dominate, as government stimulus is likely to be reduced significantly. This should see growth moderate to around 6.0-6.5%.
• The biggest risk in China in 2017 likely revolves around the political machinations of the five yearly reshuffle of China’s political leadership late in the year. Other key developments to watch in China include capital outflows and/or capital controls and any tightening in financial conditions – especially around the property market. No doubt concerns around the debt levels in China, especially at the local government and SOE level, will still linger in 2017.
• China’s relationship with US President Trump will also be critical to watch.
• In Japan, the focus is likely to be on the BoJ’s target of capping 10yr JGB yields at 0% and the expectations of further weakness on the Yen.
• The Australian economy will likely continue to see growth average around 2.5%-2.75% in the year ahead, with housing, infrastructure and net exports (of both resources and services) more than offsetting weakness in business investment.
• Concerns around Australian household debt levels have been raised by the OECD as a risk to financial stability. But household balance sheets remain in relatively good shape and with the RBA expected to be on hold we do not see significant downside risks to the Australian housing market in the year ahead. That is likely a 2018 or 2019 story also.

Since our most recent update in October 2016, the winds of change have blown through the global economy. The end to US hegemony is here and it is being driven internally as President Trump and his team focus solely on the needs of America and step back from self-imposing itself as both role-model and policeman for the globe. For the first time since 2007, global macro markets will react differently to economics and politics in a way that may seem counter-intuitive to what we have seen over the last couple of years. There is a risk that past correlations between asset classes will weaken further because the baton has been passed from central bankers to politicians, whose reactions are difficult to ascertain and change constantly with the political wind. While markets originally feared this switch, they are now embracing it wholeheartedly as the prospect of a move away from the regulatory hell of the last few years to more overt capitalism holds much allure. We believe the key beneficiary of these changes will be the US, the rest of the developed world should be pulled along in its slipstream. We have concerns though on two fronts: firstly that the Fed is likely to raise rates aggressively as fiscal stimulus risks overheating a capacity constrained US economy and this is likely to sow the seeds of the next recession sometime in 2018 or 2019. Secondly while we believe that US Dollar strength will be mild against the majors we fear that the emerging market economies and currencies (Asian especially) will suffer materially.

While we have advocated a large exposure to alternatives such as Long/ Short, Market Neutral, Global Macro and CTA strategies to mitigate risks in portfolio construction as the US economic expansion ages, we believe this policy change will likely extend the current economic expansion cycle by 12-24 months, so a rotation back into cheaper beta strategies with a high correlation to the S&P500 and ASX200 will be more appropriate for the remainder of 2017.

The United States

In the United States, President Trump has inherited quite a good story in spite of the campaign rhetoric. As expected, the foundation for economic growth continued broadening in 2016, with the middle class finally participating more fully in the recovery. The base case expectation for the United States is that growth rates will accelerate marginally, over the period from 2017 to 2018, assuming substantially lower corporate tax rates and a sharp reduction or elimination of taxes on foreign earnings are implemented later in the year.

On the back of this slightly stronger growth, slightly more upward pressure on inflation is expected and marginally higher interest rates than anticipated prior to the election. Importantly, while inflation and inflation expectations are expected to continue to grind higher, a spike in inflation in 2017 is not expected. The view that the economic recovery is broadening is based on the recent strengthening of household income and balance sheets. After bottoming at 1.5% following the crisis, annual wage growth has been slowly accelerating since 2011, and reached 2.9% in December of 2016. This trend is expected to continue as the labour market tightens further, and for wage growth to reach its pre-crisis levels of approximately 3.5%, in the next one to two years. Together with wage growth, continued jobs growth is contributing to rising household income. In 2016, median household income adjusted for inflation rose by 5.2%, the strongest increase in this metric since the survey began in 1968. This is also important as it’s not looking at average, but rather median household income. This metric takes into account both the number of hours worked and the hourly wage and is a better reflection of what is happening for middle class households in the United States that drive the bulk of consumption. Consumer balance sheets are also improving. The most important asset for the middle class (defined here as households in the 25th to 75th percentiles of net worth) is housing. For the typical middle class household, housing accounts for 60% of total assets. The S&P/Case Shiller 20-City Composite Home Price Index has now recouped 80% of the losses experienced during the US housing bust. Momentum from accelerating wage growth and the nearly complete recovery in home prices should translate into stronger consumer confidence and spending in the years ahead. The most likely result of Trump’s election is corporate tax reform with provisions to encourage the repatriation of overseas earnings. However, markets seem to have largely ignored the increased uncertainty that Trump presents given the lack of a clear policy agenda. Trump’s election has broadened the range of potential scenarios investors need to consider. So far, investors have focused primarily on the positive scenarios in which lower corporate income tax rates and increased infrastructure spending could add momentum to growth and increase inflation on the margin. Some, but not enough, investors have focused on the likely increase in budget deficits that might result from the new administration’s plans. It is particularly important to consider how Trump’s election might potentially lead to structural shifts in the economy. There are three areas to highlight: rising anti-globalisation sentiment, inflation, and interest rates.

Therefore the implications for the US economy and financial markets from President Trump is likely to involve three phases.

Phase one was ‘risk off’, with the unexpected election victory by Trump seeing the US equity market and the US dollar sell-off and US bond yields rally. This phase, however, lasted less than 24 hours, with the market quickly moving into the second phase.

The second phase, which is expected to be the dominant factor throughout 2017, is supported by the view that Trump’s policies will be expansionary and stimulatory – especially his company and income tax cuts, increased infrastructure spending and reduced regulatory environment.

This phase has already seen a strong rally in equity markets, the US dollar, a sell-off in bond markets and is expected to be the primary factor driving markets throughout 2017. A noticeable increase in both business and consumer confidence has taken place since the election.

Figure 1:  US Business and Consumer confidence

 

 

 

 

 

 

 

 

Further out, however, phase three may not be as positive. Although the timing for phase three is very difficult to determine, it could be anywhere between 2018-2020, this phase is likely to involve an increase in inflation and a more aggressive monetary policy tightening cycle from the US Federal Reserve.

Higher inflation, higher interest rates and the risks associated with Trump’s anti-trade policies could sow the seeds for an economic downturn late in Trump’s Presidency, seeing equity markets and the US dollar sell-off and bond yields rally again. As mentioned, however, the timing of phase three remains very uncertain and is unlikely to occur in 2017.

Indeed, after raising interest rates on 15 December 2016 by 25 bps, to a new range of 0.5%-0.75%, the US Federal Reserve is expected to remain on a gradual tightening path in 2017. With the Fed unlikely to pre-empt the impact of Trump’s fiscal policy easing, expect  two to three further Fed rate hikes in 2017.
Given the US economy is expected to experience a significant easing of fiscal policy from late 2017 onwards, which pushes inflation higher than previously expected and brings forth the need for more tightening from the Fed, the two- three rate hikes in 2017 are expected to be followed by another three rate hikes in 2018 and a further three rate hikes in 2019. This will give a peak in the Fed Funds target rate in 2019 of 2.5%-2.75%.

Figure 2:  Fed rate expectations

 

 

 

 

 

 

 

 

 

 

Figure 3:  US Unemployment rate and Core PCE rate – Actual and forecasts

 

 

 

 

 

 

 

 

 

In terms of the main policy agenda for President Trump, we expect the following (with the +, – and ? symbols indicating the direction of impact on the economy and markets).

+ Significant fiscal stimulus through:

+ large income tax cuts (three rates 12%, 25% & 33%),

+ company tax cuts (to 15% or 20% or 25% from 35%) and

+ a 10% repatriation tax for cash currently held off-shore.

+ Increase in Infrastructure spending, ie. $US300bn government money, with private sector involvement potentially up to $US1 trillion.

+ Increase in Military spending – current and veterans.

+ Reduce regulatory burden – especially on energy to achieve “complete American energy independence”.

– Strongly protectionist stance – name China as a ‘currency manipulator’ and impose 45% tariffs on selected imported goods.

– No support for TPP and change/withdraw from NAFTA.

– Scale back climate change regulations.

– Critical of Fed policy, pro-audit, Chair Yellen to be replaced in early 2018.

– Isolationist stance of foreign policy – critical of NATO/some allies and China. Closer to Russia.

– Tough stance on immigration – build a wall.

? Repeal and replace Obamacare.

 

It has been estimated that Trump’s policy agenda will increase the level of US government debt by around 20% of GDP over the coming decade – as shown Figure 5 below. Other estimates put the cost of the Trump tax policies at between $US2.4tr – $US5.3tr.

The key question for markets over 2017, and beyond, is: will this be money well spent? Will President Trump’s policies lead to a permanent shift higher in the US’s potential economic growth rate?

The optimists are saying ‘yes’ – that the suite of expansionary fiscal policy actions will lead to an increase in business investment, a rise in productivity and an increase in the wages share of the economy that drives growth higher.

This would then lead to an increase in the neutral level of interest rates, and an increase in the rate of return on investments.

The pessimists are much more sceptical and fear a ‘boom-bust’ cycle over coming years.

Figure 4:  US Debt expectations

 

 

 

 

 

 

 

 

Another factor that markets will need to consider in 2017 is the leadership of the Federal Reserve. President Trump will get to nominate people to fill two Governor vacancies at the Fed in 2017 and, most critically, find a replacement for Chair Yellen in early 2018 – assuming that he will not reappoint Dr Yellen. In terms of Janet Yellen’s possible replacement as Chair in early 2018, neither President Trump nor the new Treasury Secretary (Steven Mnuchin) are likely to be looking for a monetary policy hawk.

Given the extent of fiscal policy easing that is planned, the new Fed Chair will more than likely be somebody that favours a conservative approach to monetary policy and would be less inclined to hike rates substantially.

A near term source of risk to the current rosy market outlook occurs on March 15th, That’s the day that the debt ceiling holiday negotiated in 2015 expires.  The debt ceiling will freeze in at $20 trillion and will then be law.  The risk is that conservative Republican’s do not support the increase in debt so much of Trump’s promised agenda requires and that the market is expecting- so the tax cuts and infrastructure stimulus is deferred or compromised. We will be monitoring the US political situation in March to see how this issue progresses. At the time of writing the market is not viewing this issue as a credible risk.

China

From an economic perspective, China was an upside surprise in 2016 as the government boosted spending meaningfully and as credit flowed freely into the domestic economy. However, easy credit inflated fears of a housing bubble across the largest cities leading to incremental measures to clamp down on borrowing and speculation. As the year wound down, the Chinese renminbi depreciated further, increasing the pressure on the capital account as Chinese companies and residents tried to move capital outside of the country.

Looking forward, expect growth to decelerate further in 2017 and the renminbi to continue to weaken against the US dollar despite ongoing intervention by the Chinese authorities. Also expect to see the transition from an export-oriented industrial economy to a more middle-income service economy sustained.  As shown in Figure 5 below, the high-frequency data in China has been very solid through H2 2016 and so some slowdown from this strong pace of growth should be expected in 2017.

One of the bigger risk factors in China in 2017 revolves around the political machinations – with the five yearly reshuffle of China’s political leadership in late 2017.

No doubt the political leadership will be looking for economic stability ahead of the political changes in late 2017. This could imply a growth target for the year of “around 6.5%”, as opposed to the 6.5%-7% target on 2016.

Inflation in China could trend a little higher through 2017, especially given the accelerating in the PPI evident over H2 2016.

Other key developments to watch in China include capital outflows and/or capital controls and any tightening in financial conditions – especially around the property market.

 

Figure 5:  China GDP growth and Premier Li index

 

 

 

 

 

 

 

 

No doubt concerns around the debt levels in China, especially at the local government and SOE level, will still linger in 2017. It is doubtful that 2017 will be the year that these debt concerns come to a head. This is especially so given the strong desire there will be for ‘stability’ in 2017 ahead of the political changes towards the end of the year.

China’s relationship with US President Trump will also be critical to watch in 2017. Key areas of focus/concern will revolve around the currency and trade policy, as well as security issues in the South China Sea, China’s trade response and ultimately growth.

 

Europe

After adjusting its monetary policy stance in late 2016, the European Central Bank (ECB) is expected to maintain the stance of monetary policy in 2017 – with €60bn of asset purchases per month planned until December 2017.

This should help limit the sell-off in the EU bond market from any pressure for higher bond yields – especially coming from the US. A narrowing interest rate spread with the US should also put further downward pressure on the Euro – something the ECB is unlikely to resist.

Ongoing low interest rates and a weaker Euro should act to support the European equity markets and the economy more generally.

As detailed in the forecasts, the EU economy is expected to continue to grow modestly in 2017, with growth of around 1.7%, compared with the 1.6% for 2016.

Figure 6:  EU GDP growth and Core inflation

 

 

 

 

 

 

 

 

 

 

Growth should be supported by the very easy stance of monetary policy, and some minor support, if not neutral, from fiscal policy. The weaker Euro should also help those EU countries that are heavily export orientated, ie. Germany.

The risks remain, however, to the downside, with both US and UK anti-trade developments likely to weigh on the EU and the fragile nature of the banking system limiting credit supply.

Further clouding the outlook, Euro zone inflation surged to a four-year high last month, zooming past the European Central Bank’s target and piling pressure on rate setters to open talks about when and how extraordinary stimulus measures will be scaled back. Inflation in the 19 countries sharing the euro rose to 2.0 percent from 1.8 percent in January, Eurostat data showed on Thursday, the highest since the start of 2013 and just above the ECB’s target of a rate just below 2 percent.

Producer price inflation, which feeds into overall inflation with a lag, meanwhile surged to an annual 3.5 percent rate from 1.6 percent, hinting at building pressure for underlying price growth. Still, the ECB is likely to resist any call to step off the accelerator when it meets next week, arguing that the oil price fuelled inflation surge is temporary, growth is fragile and the outlook is fraught with uncertainty given elections in France, Germany, the Netherlands and possibly Italy.

Underlying inflation is also weak, holding steady at 0.9 percent last month, suggesting that once the oil price surge passes through the numbers, inflation will fall back down, staying below the ECB’s target possibly through 2019.

The key factor behind the expected upward drift in core inflation is the gradual tightening of the labour market underway and some signs of wages pressures.

The biggest sources of risk in the EU in 2017 are likely to be found in the political and banking sectors.

On the political front, three events are expected to dominate – the French Presidential election, the German general election and the negotiation strategy with the UK on Brexit.

• The 23 April/7 May French Presidential Elections. While Marine LePen (Front National) is currently trailing in the polls behind Francois Fillon (The Republicans), as we saw last year in the UK and US, the polls are not always reliable. The key risk if LePen is elected President would be a referendum on EU membership. If this were to occur, and be successful, the EU would likely disintegrate. This is not the base case, but will likely keep markets on edge until the election outcome is known.
• The German general election is expected to take place around late August-late October 2017. Chancellor Angela Merkel is running for a fourth term – a very difficult achievement. But opinion polls continue to suggest that Merkel will be able to form some sort of coalition government and remain in place. The Alternative for Germany (AfD) could do well, however, and have a strong influence on the election and the type of government formed afterwards.
• The expected activation of Article 50 by the UK in March will set the two year clock-ticking to negotiate the UK’s exit from the EU. EU negotiators have a strong incentive to drive a hard bargain with the UK and this could well be a critical factor for markets in the year ahead.

On the banking front, the Italian banking crisis is likely to continue to unfold. While the government is in the process of raising capital, it seems unlikely that it will be able to bail out the banks without support from the broader EU, which has so far signalled little appetite for this. This could be a source of tension between Italy and Germany as the Italians push further back against austerity.

 

The United Kingdom

The most significant event in the UK during 2017 is likely to be the start of the Brexit negotiation process. Article 50 is expected to be invoked in March 2017, triggering the two year process of negotiating the terms and conditions of the UK’s exit from the EU.

Not only will the terms and conditions of this exit be a source of uncertainty for financial markets in 2017, but questions still remain over the role of the UK Parliament during the negotiation phase and the final agreement.

The economic data in the UK has outperformed expectations in the months since the unexpected Brexit vote. 2016 GDP growth looks like coming in close to 1.6%.

GDP growth of 1.6% is expected in both 2017 and 2018 based on the 2016 easing of monetary policy, the weaker GBP and the expected easing of fiscal policy in the years ahead.

The downside risk remains, however, if negotiations around Brexit fail to come up with a solid new model for the UK’s trading relationship with the EU.

The pace of inflation in the UK has accelerated in recent months, driven largely by the sharp weakening in the GBP and rising oil prices. Inflation is expected to be above the BoE’s 2% target in 2017 and 2018, before returning to target in 2019.

The BoE has recently signalled that monetary policy is likely to remain on hold for the foreseeable future, with the base rate at 0.25% and a £425bn annual pace of QE. These monetary policy conditions are expected to be retained through 2017, with some minor normalisation of policy in 2018 and 2019.

 

Japan

The big event for the year in 2016 in Japan was the “comprehensive reassessment” of monetary policy. This reassessment resulted in the decision to move away from targeting the size of balance sheet expansion to targeting the 10 year JGB yield at 0%.

Figure 7:  Japan 10yr JGB and Short-end rate

 

 

 

 

 

 

 

 

For 2017 the BoJ is expected to try and hold monetary policy steady throughout the year – with the short end rate at -0.1% and 10yr yields at 0%. The trend to higher global bond yields, especially from the US, works strongly in Japan’s favour, if the BoJ can successfully hold 10yr yields down at 0%.

This would act to lower Japanese interest rates relative to the rest of the world, which in turn should weaken the Yen and strengthen the Nikkei. All this should help create some inflationary pressure in Japan and support nominal GDP growth.

Economic growth and inflation are both expected to remain modest in Japan in 2017.

For 2017 a little more economic growth is expected than that experienced in 2016, with an annual rate around 0.9%. Growth in 2017 should be supported by the renewed weakening of the Yen, further fiscal policy easing and the maintenance of extraordinary monetary policy easing.

For 2018 and 2019 growth is expected to remain modest, in a 0.5%-1.0% range, with Japan’s very negative demographics likely to hold the growth rate back on an ongoing basis.

Like elsewhere, headline inflation has shown some pick-up at the end of 2016 as energy prices rise again. Some slight improvement in underlying inflation should be seen in 2017 and 2018, but the pace of inflation is very unlikely to meet the BoJ’s 2% target in the years ahead.

Figure 8:  Japan GDP growth and Inflation

 

 

 

 

 

 

 

 

 

 

The other big event for Japan in 2017 is expected to be (another) snap Lower House election by Prime Minister Abe. This election, which could be expected before mid-year, is expected to see the re-election of Abe and the LDP – giving Abe the opportunity to remain Prime Minister until 2021 – ie. after the 2020 Tokyo Olympics Games.

In Australia, throughout much of 2016 the economic data continued to show relatively solid growth, although there was an evident slowdown in the September quarter relative to the first half of the year. Economic growth continues to be driven by exports of both resources and services, especially tourism and education, and the strength in residential construction. Infrastructure spending also remains strong, especially in NSW, while the largest source of weakness remains business investment.

The coming year is likely to bring more of the same. Consumer spending growth looks set to remain relatively modest, as consumers continue to use the low interest rate environment to pay down debt, rather than increase spending given the high amount of private debt in Australia.

The weak spot for the economy is expected to remain business investment – where both mining and non-mining investment continue to decline. Although it does appear that we are past the worst of this slowdown with resource prices beginning to climb again.

One of the most important developments in recent months and which could dominate the discussion in 2017 is the improvement in the income side of the Australian economy.

As shown Figure 9, after running well below GDP growth for the past few years, national income growth accelerated from mid-2016 onwards (even as GDP growth slowed).  While a new commodity price boom is a long way away the rebound in commodity prices of iron ore, metals and energy is pushing up national income. Amongst other things, this along with booming export volumes is leading to a dramatic shrinkage in Australia’s current account deficit which could soon be in surplus for the first time since the 1970s and the associated surge in resource company profits could knock $8-10bn pa off the Federal budget deficit.

Figure 9:  Australian GDP and income growth

 

 

 

 

 

 

 

 

 

Inflation in Australia is expected to remain low in 2017, but with the headline rate likely to drift up closer to the RBA’s 2%-3% target range over the medium term.

After having cut interest rates in May and August 2016 on the back of the low inflation environment, the Reserve Bank of Australia, under the new leadership of Dr Phil Lowe, is signalling a reluctance to lower interest rates even further.

Indeed, after the election of Donald Trump and on concerns around the level of household debt in Australia, the markets are now expecting that Australia’s cash rate has bottomed and the 1.5% interest rate will be the low in this cycle. Indeed, no change is expected in the 1.5% cash rate throughout 2017.

Figure 10:  Australian household debt levels

 

 

 

 

 

 

 

 

 

 

Conclusion

In conclusion, there is reason to be generally optimistic in terms of the growth outlook for 2017. Growth should be slightly stronger than was expected before the US election. While inflation has clearly bottomed, don’t expect a sharp acceleration in 2017. Instead, inflation is likely to grind higher on the back of wage growth with the potential for more rapid increases if protectionist policies are put in place. Interest rates are likely to rise in sympathy with inflation expectations and in reaction to Fed policy decisions, but there is a self-governing feedback loop that limits how high long-term rates can go without undermining the very economic strength that led to higher inflation expectations and interest rates. The environment for equities is positive, barring unforeseen geopolitical and policy shocks, on the back of potentially positive tax policy changes and low global interest rates. While there are some very real risks in the global economy, we doubt the will come to a head in 2017.

Executive Summary

• After forecasting four interest rate rises in 2016, the US Fed has backpedalled, and have not raised rates so far this year. Weakness in the global economy, the risk of a hard landing in China, Brexit fallout worries and domestic uncertainties have all provided good excuses for the Fed to sit on its hands since last December’s initial US interest rate rise.
• The US Fed has telegraphed a December 2016 rate rise is on the cards as the US economy is currently performing reasonably. It is close to full employment and approaching the 2% inflation target. International uncertainties also appear to have eased over the past few months.
• Both Japan and the Eurozone appear to have reached a point where quantitative easing (QE) may be doing more harm than good. In both cases, central-bank bond purchases have resulted in flatter yield curves.
• We are sticking to a more defensive investment playbook given our view that we are late in the US economic cycle. While there are no alarm bells ringing yet that suggest a US/ Global recession is imminent, an aggregate composite of indicators shows the US economy is the most vulnerable to an exogenous shock since the expansion began 7 years ago.
• Emerging market economies appear to have stabilised as the $USD has stopped appreciating against their currencies in 2016.
• While China has embarked on a stimulus program in 2016, we remain of the view that it is in a terminal structural slowdown.
• Today’s macro backdrop, which includes high PE ratio’s on stocks and low yields on bonds appears an extremely challenging one for investors.
• The Australian economy has remained resilient as the easing of monetary policy has supported jobs and economic activity in Australia. While growth and inflation remain low, wage growth has recently shown signs of stabilisation. If this proves sustainable we have likely seen the bottom of the interest rate cycle in Australia.

Consequences for asset allocation and Portfolio construction

• Our base case remains not for any global recession or crisis in 2016 or the first half of 2017, but for moderate growth in Australia and the US, accelerating growth in Japan and for China and Emerging markets to continue to slow.
• Today’s macro backdrop – which includes high P/E ratios on stocks and low yields on bonds – appears an extremely challenging one for investors looking for outsized returns in public markets.
• We find it difficult to believe how traditional pension funds and individual investors are going to meet their historical return targets in a world when $9.9 trillion of liquid fixed income instruments now have a negative yield.
• For Global stocks, we too forecast more modest returns than in the past. This more modest outlook is largely predicated on our view that multiples will contract after the 51% increase they have enjoyed since the market bottom in March 2009.
• Assuming the global environment remains stable, we believe that there is reason for optimism regarding the outlook for Australian assets over the medium term (Sydney and Melbourne residential property aside).
• This difficult environment does not mean profitable investments can’t be made, but that being patient and buying in periods of dislocation, incorporating alternative strategies, Private equity and seeking illiquidity premium will likely be required to achieve satisfactory long term results.

 

In our most recent update in March 2016, we argued the fear that markets experienced in January was overdone and that a global recession was unlikely in 2016.  Six months later, little has changed and we believe a cautious approach to portfolio construction continues to be warranted.

The big development over the year we did not expect has been that the US Federal Reserve has not yet raised rates in 2016. This lack of tightening has meant the U.S. dollar has not appreciated over the year to date which has relieved pressure on emerging market economies.  In its recent communications the Fed now appears to openly acknowledge that ongoing dollar strength could tighten global financial conditions towards an uncomfortable level. In essence, it appears that it has expanded its criteria for monetary policy changes to include not only domestic growth and inflation but also a multitude of foreign risks, China and Brexit in particular. It seems the Fed is now more concerned about the risk of global deflation, and a flat to weaker dollar helps the reflation trade by putting an implicit bid into commodity prices. Weather this persists into 2017 as inflation approaches their 2% target remains to be seen.

Our view remains that we are still in a tricky global investment environment. Our indicators still point to the notion that we are later in the US economic cycle, volatility is headed higher, growth versus value valuation divergence is extremely wide, and profit margins/returns on capital have peaked in the US. We feel better today than in January that the U.S. dollar will not restrict financial conditions as much as it has in recent years, but we remain increasingly concerned about the diminishing impact of monetary stimulus on economies around the world.

Meanwhile, equity valuations appear full in many instances, and we see limited expansion for price-to-earnings ratios from current levels. Even with relatively generous assumptions, our five-year forward expectation for Global Equities is mid to high single digit. The rise of populism in Europe, the U.S, and China looks like it will complicate the reforms needed to spur economic growth (tax reforms, sustainable pensions, focus on productivity). Instead, we see proposals to restrict trade, immigration and anti-business regulation and rhetoric. This viewpoint is important because it suggests a higher risk premium is now required to compensate for outcomes that support the politics of blame at the expense of the politics of growth.

Our view remains that we are living in a slower growth, low inflation world where economic “lift-off” speed is hard to achieve. Thus far in 2016, we see nothing in the macro data that suggests we should change our view. Financial assets with predictable cash flows now appear to be overpriced in many instances. On the other hand, more cyclical stories that lack EPS visibility now seem to be trading at a discount, particularly in unloved sectors of the market. Despite the negative overhang of Brexit, which should have near term consequences for Europe and the UK, we still think a US Recession is a little while off.

Investors should continue to expect a lower returns across most asset classes. We believe because of global QE and ultra low interest rates – many asset price returns have been pulled forward amidst below average volatility, as central banks have driven yields down to record lows. This is particularly so for long duration assets such as Bonds, Property and Infrastructure. Consistent with this outlook are two important global macro trends that we believe are worthy of investor consideration:

• First, with $9.9 trillion in negative yielding bonds, we think that there are now diminishing returns to QE at this point in the cycle;
• Second, given the recent surge in debt financing across public and private capital structures, we believe returns on incremental leverage in many parts of the global economy may have peaked and may actually be declining in many instances.

 

From 2000-2010 an investor profited handsomely by being long China Growth (Materials, Energy and Industrials) at the expense of growth-oriented stocks and certain defensive stocks. From 2010-2015, doing almost the exact opposite produced rewarding results. Today, we see a world where growth and defensive investments appear quite expensive, but we are not yet certain that all “value” parts of the market fully reflect some of the structural caution we feel about China’s slowdown and/or the difficult position that many large global financial institutions now face. As such, we think a more balanced and diversified approach is required.

We continue to look for ways to mitigate risks in portfolio construction as the US economic expansion ages.  In our opinion, when volatility is increasing and correlations are doing funny things, despite a short term low return, there is no substitute for Cash as an asset class. Meanwhile, we also think having some hedges makes sense. For most long term investors the use of alternatives such as Long/ Short, Market Neutral, Global Macro and CTA strategies are the most effective way of implementing this.

 

United States

Overall, the key recent structural story for the U.S. remains intact—namely, resilient consumer and government spending is offsetting the hit to the more cyclical parts of the economy from the energy bust and the strong dollar. GDP in 2016 looks like it will finish between 1.8 and 2.0%, and we continue to see little scope for an upside break-out to growth. While the U.S. growth outlook remains muted, one thing that has been moving up of late is the inflation outlook. We now see U.S. CPI inflation coming in at 1.5% in 2016. As we move closer to the Feds 2% target in 2017 we believe the case to raise interest rates will become more convincing.

At the September FOMC meeting the Committee statement focused on the labour market. While the unemployment rate has remained steady, Chair Yellen emphasized that more people have entered the job market and the labour market has continued to strengthen, though she did acknowledge that growth thus far in 2016 has been less robust than in 2015. Current job growth may be enough to absorb new entrants into the market, but it certainly isn’t enough to also provide jobs for those with part time jobs who want full time work. Chair Yellen also stated that economic growth had picked up from the “modest” pace of the first half of the year. The last three quarters saw GDP growth that never exceeded 1.1%; and while consumer spending was strong in July, subsequent data suggest some moderation may be afoot. Household income did improve according to the latest data release, but information from the Fed’s own Beige Book suggests that growth is still not robust. Furthermore, business investment, the engine of job growth, has stagnated. Additionally, the Chicago Fed’s national business index and its four key components all declined in August. This performance is reflected in the significant markdown in the Committee’s Summary of Economic Projections (SEP) for the second half of the year as compared with its June forecast. Finally, the Committee noted that inflation is still running below target, a shortfall again partially rationalized away as being a transitory result of the lasting decline in energy prices. But this, too, is a stretch, since energy prices have remained relatively flat for the past three months.

Looking forward, the Committee’s SEP projections appear to be contradictory. For example, both in 2015 and this year, projected GDP growth has been continually marked down for both 2016 and 2017. Q4 growth implied by the forecast is not much above 2%. This pattern, combined with a largely unchanged unemployment situation and an inflation forecast that hovers below target through 2019, makes it hard to rationalize the Committee’s stated view that inflation will be pushed back towards target in a meaningful way. For demand to hold, there must be a resurgence in wages growth that will eventually drive up prices.

So while the Committee is increasingly concerned about the need to restore policy to a more normal stance, it is struggling to understand what the neutral interest rate is or should be. That struggle has been apparent in the public statements by several Reserve Bank presidents and board members. It was heightened by the three dissents at Septembers meeting. Chair Yellen was questioned about the dissents, and she rightly pointed out that the divergence of views was a positive indication that there was a healthy exchange of views during the meeting, and that it helped to avoid “group think.” So, while the Committee may want to begin restoring interest rates to a more normal level, in the face of ongoing uncertainty, it decided to wait a bit longer before acting.

US Corporate Earnings have been at or near a peak since 2013 with S&P 500 operating results ranging between $100–$116/share through that time. Stock prices are up 27% over that time because the pull of lower interest rates has been stronger than stagnant earnings. The US Treasury 10-year note yielded 2.75% three years ago; now, it yields 1.70%. While markets ended June with a Brexit swoon, the world didn’t end, and global central banks responded, so markets recovered in July and August. The force of thinking lower interest rates for longer prevailed over earnings stagnation and tepid growth.

 

S&P 500 Monthly Index

 

 

In September this tug of war has gained volatility. Central banks and interest rates are still the driving force in markets at present. But there is a growing consensus the Fed is on the edge of their effectiveness and there is a risk that ultra low interest rates are causing systemic damage to Pension Funds and savers. Meanwhile, earnings are still flat and inflation and growth are both low. In this environment current earnings and valuation metrics make it difficult for us to get excited about adding new capital to US equities at the present time.

Europe

In Europe, we are now expecting growth of 1.3% in 2016, down from 1.9% at the start of the year. We believe there will be a material hit to growth from the Brexit vote, which we believe will cut overall European GDP growth in half over the coming six months (from 40 basis points growth per quarter in 3Q16 and 4Q16 to under 20 basis points). Although the situation remains fluid, our big concern is that the European Union has a strong incentive to play tough with the U.K., meaning this situation may get worse before improving.

We believe that Brexit is an event with significant consequences for the European economy that will only become fully apparent with the passage of time. In our view the recent vote in the United Kingdom was really a referendum on important socioeconomic issues, including immigration, trade, and productivity. As such, we would argue that this shock will be measured in years, not in months or days as was the Lehman crisis in 2008, or even Grexit in 2011. Lehman involved a real and present danger to the global financial architecture, while Grexit introduced FX redenomination risk into an undercapitalized European banking system. We see the U.K.’s recent decision to exit the European Union as a significant and durable challenge to democracies around the world, but not something that will ultimately prevent investors from deploying capital in the region over time. In fact, we are likely to see some interesting opportunities amidst the dislocation and reorganizations that are bound to occur as many corporations, multinationals in particular, adapt to the new environment. We wait patiently for investment opportunities, but think much water needs to pass under the bridge before we would be comfortable investing in Europe yet.

Interestingly, even prior to Brexit, several macro variables across Europe began deteriorating. First is the strength of the euro, which has shifted from being a 10% tailwind at the start of the year to a two to five percent headwind throughout the first half of 2016. Without question, the euro’s sudden reversal was a big part of Europe’s dismal first quarter earnings season. Just consider that in the first quarter of 2016, 20% of companies missed their revenue estimates, the worst revenue miss in 10 quarters. Second, European regulators have punished banks beyond what most commentators expected to see – often with painful side effects. In fact, it looks like the regulatory tightening has effectively offset European Central Bank (ECB) accommodation, so that financial conditions in the Eurozone are worse now than they were at the start of the year, despite substantial further easing from the ECB. Thirdly, the European residential construction sector appears to be slowing.

In terms of inflation, we are now expecting just 10 basis points of inflation for 2016, compared to a 1.0% expectation at the beginning of the year. This reflects our expectation of weaker demand following Brexit. In addition, oil remains a major headwind to inflation, and is down 20% year-over-year in euro terms. Moreover, we note that each of the four major inflation sub-categories, including food, alcohol & tobacco, energy, services, and non-energy industrial goods, has either deteriorated or stood still, in year-over-year terms, since December 2015.

 

Even before Brexit, four of five key GDP drivers had turned less supportive

 

Data as at June 5, 2016. Source: Bloomberg, Eurostat. Eurozone residential permits are indexed to 2010=100. The Bloomberg Financial Conditions Index is indexed so that zero is the divide between accommodative and contractionary conditions.

 

China

While we remain concerned about the short to medium-term outlook for China, we do not believe that China is about to have a financial crisis or experience a hard economic landing. China’s rapid economic growth in recent years has been unsustainable and when demand for Chinese manufacturing exports deteriorated in the global financial crisis (GFC), China launched the largest credit stimulus in history, fuelling an investment boom that continues today. From 2008-2013, China’s state owned banks issued new credit of US$10 trillion, equivalent to the entire US banking system. Although credit growth has slowed, it continues to grow at 15% per annum. The problem is that GDP benefits from new loans have fallen from around 75 cents per dollar of loan to just 20 cents. Currently, it is estimated that $1.3 trillion in corporate loans are owed by Chinese companies whose profits aren’t sufficient to cover interest payments, which suggests potential bank losses of around 7% of GDP (excluding shadow banking exposures).

Almost half of China’s credit growth since the GFC (or around 50% of GDP) may have gone towards financing property market activity. There appears to be approximately four years of excess housing supply in China, comparable to recent property booms in the US, Spain and Ireland. According to the China Household Finance Survey, 22% of urban housing in China is vacant. Meanwhile, vacant floor space on developers’ books has increased by around 500% since 2007. Property prices are growing rapidly in Tier 1 cities with supply shortages, but are stagnant or falling in lower-tier cities where most of the excess supply is located. The potential implications of China’s property oversupply are serious, with real estate and related industries accounting for 20-25% of China’s GDP. Fiscal positions are vulnerable, particularly for local governments who have relied on land sales for 35- 40% of revenues. A large contraction in China’s property construction sector would cause a major slowdown in the economy and perhaps even a recession. Although economic data out of China is problematic, a range of indicators suggest that China’s economy is slowing as the housing oversupply problem broadens. Weakness is most apparent in the industrial space (41% of GDP), a large portion of which is linked to property. Cement production contracted by 2% per annum from 2013 to 2015, compared to 11% growth per annum in the decade prior. Steel production, electricity production and freight traffic have all slowed materially, growing at just 1-2% per annum in the past two years.

Although industrial sector data showed signs of improvement in early 2016, we believe this is due to a temporary credit stimulus by the Chinese government. Real trade data also shows that imports have slowed materially, while exports are contracting. Since 2010, China has contributed around a quarter of total global economic growth, despite its economy only representing around 12% of world GDP. We are cautious about adverse knock-on effects, including currency movements, linked to changing economic fortunes in China. A number of commodity exporters such as Russia, Brazil, Australia and Canada have experienced material depreciations in their currencies against the US dollar as commodity prices have fallen. Asian economies with strong trade and financial linkages to China could also be at risk. The outlook for the Chinese renminbi, which has appreciated around 50% on a real trade-weighted basis since 2005, is uncertain and difficult to predict. While modest RMB depreciation is likely over time to partially offset rising wages, a large devaluation is less likely.

In early 2016, China introduced new and tighter capital controls that appear to have stemmed outflows, at least for the time being. Chinese policymakers must carefully manage the credit and property excesses in its economy. If China moves too quickly to address the moral hazard and implicit government guarantees in its financial system, this could lead to a tightening of credit conditions and a pullback in loan demand from the private sector, triggering an economic downturn and possibly a panic in the poorly regulated shadow banking system. On the other hand, if credit stimulus continues unchecked or is ramped up to maintain GDP growth rates, returns to new credit may diminish further and result in material loan losses in the future. The Chinese leadership appear to be aware of the problems and have the policy tools needed to stabilise the economy; this makes a financial crisis unlikely. Fortunately, most of China’s debt is held domestically, which makes it easier for the government to manage large-scale defaults, as it did in the late 1990s. Further monetary stimulus will almost certainly be deployed to reduce interest burdens and ease banks’ reserve requirements. Meanwhile, a huge pool of foreign exchange reserves and a large current account surplus make China resilient to external financial shocks.

China’s GDP growth will rise and fall with stimulus, but the structural trend is downward sloping

 

`Data as at March 31, 2016. Source: China National Bureau of Statistics, Haver Analytics.

 

Japan

It is well known Japan has been suffering from weak economic growth for the past two decades, along with stubborn deflation, ever-rising government debt, and an ageing and declining population. The BOJ has pursued quantitative easing, first during 2003–2006 and then on a much more massive scale since April 2013. This past January the BOJ announced it would supplement its QE program by setting a negative policy interest rate. These policies have clearly lowered interest rates and pumped enormous liquidity into the Japanese economy. However, spending by consumers and businesses has remained sluggish, and there has been no progress toward the BOJ’s objective of 2% inflation.

In September the BOJ announced a major resetting of its monetary policy, based on a “comprehensive assessment of the developments in economic activity” under its policy of “quantitative and qualitative monetary easing (QQE)” together with “negative (policy) interest rate” and a “price stability target of 2%.” The revamped policy is called “QQE with Yield Curve Control” and is combined with an “‘inflation-overshooting commitment’ in which the Bank commits itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price stability target of 2% and stays above the target in a stable manner.” These are very significant changes.

The yield curve control policy means the BOJ is now going to focus on the yield curve and, more specifically, target the yield on 10-year Japanese government bonds (JGBs) “so that 10-year JGB yields will remain more or less at the current level (around zero percent).” These changes towards rate targeting and increased flexibility in the Bank’s quantitative easing should dampen the debate about the possibility of the Bank running out of assets to buy and should address concerns about the excessive flattening of the yield curve and the adverse effects of the negative policy interest rate on banks and pension funds. The change in the inflation policy target to one of overshooting the 2% rate “in a stable manner” is clearly a dovish move, signalling to markets the strength of the BOJ’s commitment to press ahead with all means at its disposal to counter deflationary tendencies and achieve its price stability objective. This implies that monetary base expansion will be continued indefinitely.

We consider this policy revamp by the Bank of Japan to be positive for the Japanese economy and its asset markets. The Bank’s targeting of the 10-year bond rate while increasing the flexibility of its quantitative easing and maintaining its negative policy interest rate is clearly a move into uncharted waters. BOJ Governor Haruhiko Kuroda stated that controlling the yield curve is “quite doable.” It will likely be a challenge. There is no immediate increase in monetary policy stimulus from the policy reset. The changes should, however, reduce the negative effects of the Bank’s policy and make it more sustainable and easier to expand in the future. The new inflation target should give a needed boost to inflation expectations. These developments may eventually lead to some easing in the exchange rate for the yen, although the expected steepening of the yield curve and the US Fed’s delay in raising rates could work against yen depreciation.

 

Australia

Ever since the mining boom ended several years ago it seems the Australian Economy has been stuck in a slow grind. Unemployment at 5.7% and labour underutilisation at over 14% are higher than the Government would like and the Sydney and Melbourne property markets appear too hot. We are likely to see an oversupply of apartments in the next year or two and household debt levels are very high by international standards. This is cause for some concern.

As the biggest boom in our history has ended, it has hit our investment and national income. Given these events the $A is arguably still too high. Profits of listed companies fell around 7% over the last financial year. The RBA believe wage growth and inflation are still too low for comfort. The recent Election has not provided policy certainty, with a difficult Senate and no political ability to control the budget and undertake hard economic reforms.

Despite the highly publicised difficulties, there are some causes for optimisim that the worst may be behind us. First, economic growth is pretty good with the economy expanding 3.1% over the year to the March quarter and looking similar for the June quarter. This is in line with Australia’s long term average. It’s also way above most other advanced countries.

It appears the economy has successfully rebalanced. The slump in mining investment and national income due to the collapse in our export prices has been offset by a surge in housing construction, solid consumer spending, a pick-up in services exports and a surge in resource export volumes.

 

Source: ABS, AMP Capital

As a result of all this, post mining boom weakness in WA & NT is being offset by strength in NSW and Victoria as the much talked about two speed economy of several years ago has just reversed.

 

State of the States, annual % change to latest

 

Source: ABS, CoreLogic, AMP Capital

The worst of the slump in commodity prices and mining investment looks to be behind us. After sharp falls from their highs around the turn of the decade global prices for iron ore, metals and energy have stabilised as greater balance has started to return to commodity markets and the $US has stopped surging higher. While a new commodity price boom is a long way away the stabilisation should help our terms of trade and national income.

After falling for three years from a peak of 7% of GDP, mining investment intentions indicate that mining investment will have fallen back to around its long term norm of around 1-2% of GDP by mid next year. Reflecting the slump in mining investment, engineering construction has now fallen back to near its long term trend indicating that the wind down in the mining investment boom is almost complete and that it will be less of a drag on growth next year. This is important because the slump in mining investment has been knocking 0.5 to 1 percentage points off annual GDP growth over the last three years.

Source: ABS, AMP Capital

Public infrastructure investment is also ramping up strongly. This is partly driven by former Federal Treasurer Joe Hockey’s Asset Recycling Initiative that is seeing new state infrastructure spending, particularly in NSW and the ACT, financed from the privatisation of existing public assets. The upshot of a fading growth drag from mining investment and rising public capital spending is that it will offset the inevitable slowing in housing construction that we will see next year.

On the share market, profits have likely bottomed. 2015-16 was not great for listed company profits with earnings per share down around 8% driven by a 47% slump in resources profits and a 4% fall in bank profits. But it is notable that 62% of companies have seen their profits rise on a year ago and the typical or median company has seen profit growth of around 4%. While aggregate dividends fell 10% mainly due to a cut in resources company dividends, 86% of companies actually increased or maintained their dividends indicating that the median company is doing okay.

 

Source: AMP Capital

Overall profits are on track to return to growth in 2016-17 as the slump in resources profits reverses (thanks to higher commodity prices, cost and supply controls) and non-resource stocks see growth. 2016-17 earnings growth is expected to be around 8%.

 

 

Source: AMP Capital

The bottom line is that the recession many said was inevitable as a result of the mining bust hasn’t happened.

 

Sources:
ANZ Bank (September 2016)
Cumberland Advisors, (September 2016)
Bank of America/ Meryl Lynch (September 2016)
Magellan Financial Group (August 2016)
Lazard asset management (August 2016)
PIMCO (August 2016)
KKR (August 2016)