The synchronised global expansion continued in August despite increasing tension between North Korea and the US. Most financial markets regained their composure by month end with the FTSE100 gaining 59 to 7,430. The S&P 500 was unchanged at 2,471 – the narrower based Dow Jones and technology focused Nasdaq indices both rose – although the FTSEurofirst fell 15 to 1,469 and the Nikkei 225 279 to 19,646. Asian and emerging markets gained between 2% and 5%. The flight to safety combined with lower than expected inflation saw bond yields fall with the US Treasury 10 year reaching a 2017 low of 2.1% and the UK 10 year below 1% at one point. Euro appreciation pushed sterling closer to parity at €1.08 and it was also weaker against the dollar at $1.29. Brent crude was stable at $52.
Global growth surprised on the upside in Q2 and remains robust with the latest purchasing manager surveys suggesting there is more to come. Unlike the downward revisions seen at this stage in previous years, GDP estimates are little changed at 3.1% for 2017 and 3.3% in 2018. Industrialised economies are expected to grow by just over 2% this year and next compared with 4.5% for emerging economies. Both are experiencing broadly based growth with only Venezuela, Brazil, South Africa and Greece in or close to recession. However, the pick up in the industrialised economies next year will depend on a US fiscal boost being agreed this autumn. Labour markets are improving with strong jobs growth taking unemployment down to its lowest level since 2008. Global fixed investment is also strong and, in the absence of a Trump trade war, the volume of traded goods should easily exceed growth rates in previous years.
Global inflation of 2.4% continues to lag expectations particularly in the US where core CPI (1.7% year on year in July) has surprised on the downside for five consecutive months. The outlook remains benign with producer price inflation falling sharply thanks to lower commodity prices and moderate wage growth. US inflation could remain below 2% well into 2018 although the picture elsewhere is rather different with the 1.1% average in other industrialised economies rising. Eurozone core inflation of 1.2% in July was the highest since 2013. This is still an environment of very low numbers but regional trends could provide clues to central bank policy on quantitative tightening and future bond yields.
As markets had been preparing for global tapering, the Jackson Hole Economic Policy Symposium and US and ECB central bank meetings proved an anti-climax. Greater confidence in global growth, improving employment and deleveraging of commercial bank balance sheets all suggest some tightening in monetary policy is justified. Net asset purchases have declined from their mid-2016 peak to $100bn per month and central banks have already announced plans to scale these back to zero by the end of next year. The Federal Reserve is expected to start reducing its balance sheet by $10bn per month in October and $50bn per month later in 2018 and will reinvest less as assets mature. The ECB will announce by the end of next month how it intends to scale back asset purchases from €60bn to €40bn.
The direct impact of gradual tapering on the US economy is likely to be modest for two reasons. Firstly, $10bn is a very small proportion of annual $2,337bn Treasury Bill issuance. Secondly, most of the quantitative easing ‘money’ has ended up as commercial bank depository reserves rather than extra cash in circulation – which would have been highly inflationary and put pressure on the dollar. The restructuring of commercial bank balance sheets and moderate lending growth mean banks have more than adequate reserves so ‘shrinking’ the Federal Reserve balance sheet is unlikely to lead to much tighter financial conditions. Some research suggests the rise in bond yields could be limited to around 60bp over the unwinding period. The anticipated impact of tapering on the direct economy may explain why the focus at Jackson Hole was on financial stability as some cyclical measures – for example the valuation of the S&P 500 to GDP – are at historic highs. With interest rate expectations some way below the Fed’s ‘dot plot’ forecasts, continued strong economic growth may well pose more of a risk for markets than tapering. However, given the low inflation outlook we think central banks are unlikely to allow financial conditions to tighten so significantly that this triggers a rise in corporate defaults or a retrenchment in consumer spending.
The latest corporate reporting season confirmed that Q2 sales and earnings grew strongly in the US, Europe and Japan. Although close to cyclical highs, profit margins continue to expand helped by slowing inflation and subdued wage growth. The cycle has reached the stage where investment in productive capacity is likely to rise to counter-balance anticipated wage increases and both corporate fundamentals and financial conditions are supportive. A recurring theme among the companies we research is the disruptive impact of new technology on traditional business models. An example is advertising/media where technology companies are muscling in on established players but it is difficult to value the ‘disruptors’ as their cash flows do not match those of more traditional companies.
We remain positive on the outlook for global equities on the basis that the supportive monetary backdrop, growth and inflation will lead to above average corporate profit gains over the foreseeable future. The prospective valuation of 15.5x is around the 20 year average – well below the 25x peak – and alternatives such as bonds do not look good value in nominal or real terms even if, as we expect, yields remain low. Regionally, we favour the Eurozone and Japan as both are experiencing a catch up in cyclical corporate profitability although further euro strength will reduce the attractiveness of some companies. We are currently neutral on the UK but this is in a global rather than a ‘local’ context and primarily reflects sectoral bias rather than below average GDP growth or Brexit.
