The global economy is enjoying a sustainable economic expansion with a long-awaited recovery in investment, manufacturing, domestic demand, and trade.
For the first time in a decade, major developed and emerging economies are in a sweet spot, enjoying cyclical growth upswings with indications that this strength should continue into 2018. These conditions represent the lagged success of worldwide extraordinary monetary policy in finally boosting global growth. Expectations of more robust and broad-based global demand, a pickup in investment spending, improved worldwide corporate profitability, and subsequent optimistic financial markets are all positive occurrences. The International Monetary Fund (IMF) projects global growth to rise from 3.6% in 2017 to 3.7% in 2018.1 As the effects of the financial crisis finally fade across economies, expectations are for growth to accelerate in many countries over the next 12-18 months.
Developed Markets—Entering 2018 From a Position of Strength
The U.S. is in the ninth year of its economic recovery, the third longest since 1900. Nevertheless, the recovery has been quite shallow compared to previous upturns, so much so that nominal GDP, based on Q3 2017, would be 6.4% higher, or $20.8 trillion, if growth was in line with the historical median at this point of the cycle. Recent trends in the data point to an improving economy as evidenced by consecutive quarters of 3%+ GDP growth, stronger than expected and the best since 2014. Consumer confidence has climbed to the highest level in 17 years; business investment is on the rise; productivity has picked up; and Purchasing Managers’ Indices (PMIs) show the dynamism on the manufacturing and the service sides of the economy. If Congress is successful in passing a tax overhaul, then there may be a near- and medium-term boost to activity and investment, helping to extend the cyclical recovery. Whether a fiscal boost can be successful in shifting long-term structural trends in the economy is another matter and represents something of a real-world social science experiment. Even as the Federal Reserve (the “Fed”) embarks on its shallow tightening plan, current financial conditions are easier than normal with record high asset prices and tight credit spreads. As a result, we believe that easy financial conditions can absorb the Fed’s short-term rate hikes and will be supportive of the real economy and of markets.
While many reads on the U.S. have trended upwards in 2017, several issues remain as possible sources of risk to this rosy picture. The most pressing is the interplay between the inflation puzzle and the incoming Fed chair, Jerome “Jay” Powell, and the new members who may fill vacant seats on the board. Despite historically low levels of unemployment, wage growth remains tepid and inflation has consistently undershot the Fed’s 2% target.
Nevertheless, many observers believe the tight labor market and buoyant financial conditions will eventually produce higher inflation in 2018 and 2019. While the market considers Powell to be a dovish choice in the Janet Yellen mode, we actually don’t know how he or the other members would react to new data. We also don’t know how a “Powell Fed” would react to continued low inflation accompanied by distortions in financial markets and asset prices. Further, the Fed has promised to raise rates three times in 2018 as part of its slow climb back to normalization; the market is currently expecting only one or two rate increases in 2018. This disconnect alone is a source of risk to the markets.
Europe is notably strong, with all countries experiencing positive GDP growth rates and most at an accelerating pace. Nearly all indicators are trending higher to paint a picture of a firming economy that gathered pace through 2017 and is entering 2018 with momentum. Manufacturing and services activity is the highest it has been in several years; consumer and business sentiment is strong, with the former at the highest it has been in 16 years; earnings growth is the strongest it has been since August 2011; and the labor market has made significant progress as the unemployment rate has come down, although it is still not at the pre-crisis low.
And with inflation remaining subdued, the European Central Bank (ECB) is expected to continue its accommodative policies for several years. The ECB will maintain quantitative easing at a reduced pace well into 2018 and may not embark on a tightening cycle until 2019. Peripheral Eurozone credit spreads (Portugal, Italy, Ireland, Greece, and Spain) have tightened compared to German bunds, indicating decreased risk to local economies and support for risk assets. With Europe’s cyclical recovery lagging that in the U.S. by several years, we expect conditions in Europe to remain strong in 2018.
Nevertheless, there are some landmines, as evidenced by the 2017 elections in Europe. Even as the potentially disruptive elections (Netherlands, France, Germany) instead resulted in market-friendly outcomes, and thus lowered risk premia, the British, German, and Austrian coalition-building within governments reveals fragility and discontent vis-a-vis current policies. This undercurrent of dissent will not soon disappear and is likely to influence markets heading into 2018 and beyond.
The UK economy continues to reflect home-grown weakness due to both the uncertainty surrounding the Brexit process and the revaluing of the pound. The resilience of the UK economy on the back of the 2016 June Brexit referendum began to fade by the end of 2017. As currency depreciation and higher inflation hit real incomes in 2017, consumer spending dropped, the household savings ratio fell, and services investment intentions weakened. The UK consumer has been one of the main engines of growth and weak consumer spending is expected to leave the economy on an unsteady footing in 2018.
On the other hand, business investment has remained within its recent positive range. Going forward, key factors in the UK economic outlook include whether real investment can continue to hold up and whether declining consumption trends can be reversed given the support of tight labor markets and strong household balance sheets. In addition, export sectors are benefiting from the weaker pound and supportive regional and global economies.
In Japan, Shinzo Abe’s decisive victory in snap elections and the ongoing rally in the Japanese market suggest that the Japanese economy is likely to remain on a cyclical upswing. The economy has delivered seven positive quarters of growth in a row (quarter over quarter), business confidence is at a 10-year high, the stock market is at a 26-year high, and unemployment is below 3%. It is likely that Haruhiko Kuroda will be reappointed as Bank of Japan (BOJ) governor in April 2018, ensuring the continuation of accommodative monetary policy unless there is clear evidence of inflationary pressures. The BOJ is lagging both the Fed and the ECB in normalizing policy, and is expected to continue asset purchases and keep their yield target on the 10-year Japanese government bond around 0%. A clear risk to the market is that the BOJ owns 46% of the outstanding Japanese government bonds and the balance sheet amounts to 90% of GDP. With growth in the leading economic indicator index at a multi-year high, Japan is expected to continue to improve despite the clear risk to markets that may be ahead when the BOJ eventually embarks on a path to normalization.
Emerging Markets—Improving Growth but Risks Remain
Emerging markets had a banner year in 2017 and are expected to accelerate into 2018, with growth remaining above developed markets. The synchronized global upswing has boosted global economies and has created a supportive environment with increased emerging and developed market demand, accelerating global trade, and gradually increasing commodity prices. Continued accommodative monetary policy and a dovish tightening cycle in the developed economies boosted capital flows to emerging markets and have supported local markets. As emerging markets are increasingly a larger portion of the worldwide economy, they are trending to be a broad indication of where global growth is headed. While today, emerging markets (EMs) are nearly 40% of the global economy, with China alone at 15%, that portion is expected to grow to nearly 45% in the next five years. According to the IMF, the growth rate for EMs is forecasted to rise to 4.6% in 2017 and 4.9% in 2018, and plateau at 5.0% in the medium term.
In addition, relative to 24 months ago, and despite recent fears of a slowdown, global trade has accelerated. This increase in trade is broad-based and is evident both in developed and emerging economies, bolstered by a recovery in global demand, increased capital spending, and a pickup in real activity in Asia, led by China.
The risks to EM growth are mostly idiosyncratic and come from policy uncertainty in places like Turkey, Brazil, and Mexico due to recent NAFTA (North American Free Trade Agreement) uncertainty. China’s rapidly growing debt burden has yet to be unwound, adding additional concern to the outlook as the impact of the economic transition away from exports and investment remains unclear. Further, EM growth rates and asset prices tend to be highly sensitive to monetary tightening cycles in developed economies. To the extent that policy normalization in the U.S. is faster than expected, with a concurrent strengthening of the U.S. dollar, EM markets could come under pressure. Further, the specter of protectionist policies remains, with a tug of war taking place between some members of the administration, their supporters (including some Democrats) in Congress and the free-trade members of the Republican Party. The protectionist voices were quieted in 2017 but EM economies nevertheless remain vulnerable to changes in trade policy.
Central Banks—A Dovish Tightening Cycle
Central banks have responded to quickening economic activity by signaling the coming of policy normalization. In the U.S., the Federal Reserve’s Federal Open Market Committee announced the beginning of unwinding of the Fed’s $4.5 trillion balance sheet and intends to continue with gradual rate increases. Jay Powell expects the balance sheet to shrink to $2.5-$3 trillion in four years’ time, meaning that it will be significantly larger than when the Fed embarked on extraordinary monetary policy. While the Fed has laid out three rate increases for 2018, the market is only expecting one or two hikes because of the persistent low-inflation reports. If the market moves towards the Fed’s expectations, it will have to account for a large increase in financing costs, which is not being priced into the market. Yet, even as the Fed is raising rates, financial conditions are easier than ever, boosting the economy and capital markets.
The ECB has indicated that it would scale down its bond-buying program even as it extends it well into 2018, if not longer. Rates will not rise until the end of the bond-buying program, which pushed back market expectations for an ECB interest-rate increase deep into 2019. In Japan, monetary policy will remain highly accommodative as its economy recovers, with the BOJ adding to its securities and the 10-year Japanese government bond yields remaining pegged at zero.
This activity points to a couple of conclusions: central bank balance sheets in the aggregate may not begin to shrink until 2020 at the earliest, and the pace of the reduction will be significantly slower than the pace at which aggregate balance sheets expanded. Therefore, quantitative easing will not be fully reversed in the near or the medium term and central banks will continue to be accommodative. In addition, the beginning of quantitative tightening in the U.S. and the deceleration of quantitative easing in Europe was well articulated by the central banks and therefore well anticipated by the markets. Likewise, the rate hike cycle in the U.S. is unusually slow given the buoyant state of the economy. In short, our view is that taken on its own, the ending and reversal of quantitative easing is unlikely to derail the global economic recovery.