Synchronised global growth, low inflation, favourable financial conditions and higher corporate profits have supported risk assets for much of 2017. The linear rise on the S&P 500 continued in September with the index gaining 48 to close at an all-time high of 2,519. The FTSEurofirst 300 has been more volatile but rose 55 to 1,524 with a similar percentage gain on the Nikkei 225 which closed at 20,356. After performing strongly this year, Asian and emerging markets were little changed in September. The FTSE100 has been lagging most major markets and fell 58 to 7,372 while the domestically focused FTSE250 mid-cap index managed a small gain and year-to-date has out-performed by a considerable margin. Dollar weakness saw the euro strengthen to €1.17 and sterling rebound to $1.33. Brent crude recovered to $56 and geopolitical uncertainty helped gold rise to $1,273. The prospect of central banks co-ordinating tighter liquidity conditions resulted in higher bond yields with the UK 10 year gilt at 1.36% – close to its level at the start of 2017 after dropping below 1% mid-year.
Global growth forecasts have been marginally upgraded during 2017 with GDP now expected to rise 3.1%. In the industrialised economies, 2.1% growth continues to be eclipsed by 4.5% in the emerging world. The pick up in global trade and investment, as well as robust business sentiment surveys, suggest global GDP could be 3.3% in 2018. Inflation in industrialised economies fell in the first half to a 1.3% low in June. Despite unemployment at mutli-year lows, globalisation of the supply chain and product/process innovation is still dampening inflation with CPI expected to rise marginally to 1.6%.
Asian and emerging economies are benefitting from the cyclical trade upturn and export growth appears to be broadening from IT to machinery and vehicles. Global business investment intentions indicate that the momentum will continue and boost demand for value-added goods needed for digitisation – such as specialist semiconductors – more than commoditised volume components like household appliances and toys. The growth opportunities for these economies could be even greater if there had more progress on tackling structural and regulatory challenges. China and India’s near 7% growth rate will fall marginally next year reflecting policy adjustments for the transition to long-term sustainable levels. Despite a downward revision in Q2, the Japanese cyclical upturn remains well supported by business investment, a sharp increase in corporate profits and urban redevelopment for the 2020 Tokyo Olympics. Japanese PM Abe has called a snap election to capitalise on his rising popularity as the threat from North Korea escalates.
Boosted by anticipated personal and corporate tax cuts and hurricane-related government spending, the US is on track to expand 2.2% this year and 2.7% in 2018. The recent storms have had a direct impact on around 10% of the economy and may reduce Q3 GDP by 0.5% although government expenditure should increase Q4 by a similar figure. Some spending – for example on services – may not return but, with an estimated 500,000 vehicles needing to be replaced, consumers could more than make up for this. Scarcity of gasoline and building materials may temporarily increase headline inflation but will have limited impact on 1.4% core CPI.
In terms of economic growth, the surprise this year has been the broad-based recovery in the Eurozone which is now catching-up with the US. Like Japan, the region is benefitting from the cyclical upturn in global trade – exports should increase 4.6% year-on-year – as well as a strong rise in domestic construction and investment. Private consumption is steady rather than spectacular which suggests euro strength may constrain exports next year. Spain, Ireland and the Netherlands are notable highlights but Italy remains a laggard and faces an eclectic range of candidates for the 2018 general election. Meanwhile, the German election result has weakened Chancellor Merkel’s position with a coalition increasing the likelihood of further sizeable fiscal stimulus and criticism of European Central Bank quantitative easing. Negative bond yields out to seven years are having an adverse impact on the financial stability of small unprofitable German banks. The ECB is due to announce tapering plans and possibly a first interest rate hike in late October.
UK GDP growth of 1.6% is at the bottom of the G10 league table. Continued Conservative Party infighting and EU intransigence increase the risk of a leadership challenge and another election. The political uncertainty, combined with the lagged impact of sterling depreciation, has knocked consumer confidence as real disposable incomes come under pressure. However, unemployment continues to fall, wages and house prices are off their lows and business indicators remain in expansion territory so the economy is likely to muddle through. The sharp rise in inflation should soon unwind but in late September the Bank of England still managed to surprise financial markets by signalling that the rate cut after the EU Referendum could be reversed in Q4 – the first increase for 10 years. The re-pricing of interest rate expectations led to short-covering in sterling and higher bond yields. The latter are likely to be capped at current levels pending international developments, higher wage inflation, an end to the BoE’s Asset Purchase Facility and action to eliminate pension deficits.
Central bank asset purchase tapering and the increased likelihood of interest rate rises have unsettled bond markets. When the Federal Reserve last signalled a liquidity reduction in 2013, 10 year bond yields rose 140bp and emerging markets caught a severe cold. This time, the move has been better flagged and primarily reflects improving economic conditions albeit financial stability and political factors – notably growing social inequality – have also influenced decision makers. The direct impact on the real economy and sovereign debt bond yields may be limited despite the planned drop in net asset purchases from $100bn per month to zero by the end of 2018. The most vulnerable assets appear to be emerging markets and less liquid securities – including corporate bonds with European issues more at risk than relatively liquid US issues.
The corporate operating environment is favourable with profitability, helped by recovering energy and commodity prices, expected to rise 15% this year and 10% in 2018. In contrast to recent years, more companies are benefiting from revenue growth as higher nominal GDP boosts sales and reduces reliance on cost cutting. However, sterling weakness means input cost pressures and squeezed margins for some UK companies. At 17x, equities are not cheap but nor are they at extreme levels and attractive dividend yields mean they still look good value against bonds. Our equity preferences evolve with the business cycle: strong growth in the early stages of rising bond yields favours resource, cyclical and financial sectors rather than defensives and utilities while technology and construction tend to perform well during periods of steady growth. We remain focussed on companies with strong balance sheets and free cash flow that can enhance returns through dividend increases and share buy backs.
