Robust global growth, low inflation and negative real interest rates should provide a supportive backdrop for financial markets. Global GDP is expected to accelerate again next year to 3.4% – well above the 2.5% achieved in 2016. Although inflation remains below target, central banks are taking the opportunity to normalise monetary policy with small interest rate increases over an extended period. The policy change signals a turning point in the cycle for fixed interest markets. With the Federal Reserve signalling another rate rise in December and possibly two more in 2018, yields on 10- year sovereign debt in the US, UK and Europe are expected to increase by 30bp-50bp to 2.75%, 1.6% and 0.75% respectively over the next 12 months. As this incremental approach is unlikely to derail economic growth, further corporate profit gains should underpin equity valuations.
Many markets hit new highs in October with the S&P 500 up 56 to 2,575, the FTSE100 120 to 7,493 and the FTSEurofirst 300 28 to 1,552. Japan produced the best gains, with Prime Minister Abe’s strengthened political position and a recovery in corporate profitability powering a rise of 1,655 points on the Nikkei 225 to 22,011. The cyclical/global trade upturn was reflected in gains of 4%-5% from Asia and emerging markets. Restraint by Russia and key OPEC members is helping to stabilise the supply/demand balance and should limit oil price volatility.
Economic forecasts have changed little since the start of the year, and recent improvements in business investment and productivity suggest further upside potential. US growth is expected to accelerate from 2.2% this year to 2.7% in 2018 supported by solid consumption and a long-awaited fiscal boost. The tax reform bill proposes significant reductions in corporate taxation and encourages companies to repatriate overseas profits. Assuming it is enacted, the benefits should be seen towards the end of next year. The housing market has been distorted by unusual weather patterns but the impact appears to be less than feared, and growth should resume alongside higher corporate investment and a modest rise in government spending. While the upturn in activity is a far cry from President Trump’s over-optimistic promises, jobs growth is still well above the replacement rate with unemployment likely to drop below 4% in 2018. Inflation will remain under 2% despite some signs of wage inflation. Jerome Powell, recently nominated to chair the Federal Reserve, is expected to continue the policy of incremental rate rises, although he may place more emphasis on financial stability than his predecessor. Market pricing of forward interest rates is still below the Fed’s ‘dot plot’ projections, and this represents a risk if economic activity is materially higher than forecast.
Growth of around 1.6% in Japan is also expected to be above trend reflecting strong exports, a modest rise in consumer spending and a pick-up in business investment. Despite the tightening being implemented elsewhere, monetary policy is likely to remain supportive ahead of the proposed consumption tax increase in October 2019. Japan’s Asian neighbours continue to grow strongly. President Xi appears to have consolidated his position by announcing that China is entering a new era of economic and political development. While his lengthy speech to the National Party Congress was somewhat short on detail, measures already in place to cool the property market and stricter enforcement of environmental regulations suggest some moderation in the current growth rate. Chinese activity in commodity markets continues to be influential, albeit not always predictable, as demonstrated by the divergence in copper and iron ore prices this year.
The catch-up in the Eurozone over the last 18 months may have peaked, now that growth is broadly in line with other industrialised economies. This has been broad-based and, so far, euro strength has had little impact. Unemployment of 9% means capacity constraints are less likely than elsewhere, and gives the European Central Bank headroom to commit to asset purchases until at least September 2018 – quashing speculation of an imminent interest rate rise. The anticipated fiscal boost to the German economy could be delayed by coalition talks. Activity in France is the strongest for six years and increases President Macron’s chances of introducing major structural reforms in areas such as unemployment insurance and vocational training. Ireland heads the GDP league table with growth of 3.5%, but faces Brexit challenges. Italy is benefiting from the cyclical upturn and growth in Spain is strong, although both countries face significant political challenges in 2018.
With Brexit dominating the headlines, UK GDP growth of 1.5% is near the bottom of the league table, with surveys indicating that softer conditions in services and construction are offsetting increased manufacturing activity. A house building shortage means that, so far, there has only been a slight decline in property prices. Political uncertainty and the squeeze on real disposable income from sterling depreciation has resulted in consumers scaling back ‘big ticket’ expenditure, including cars, while reports from retailers suggest the structural move from ‘bricks and mortar’ to internet shopping has been accelerated by a search for value. Relatively buoyant consumer confidence reflects a robust employment market and – although wage increases remain modest – the net fall in immigration could lead to pressure building. The Bank of England raised interest rates by 25bp to 0.5% on 2 November. Another increase can be expected next year as part of monetary policy normalisation but negative real rates will limit a further recovery in sterling, which ended October slightly weaker at $1.32. Social inequality is another factor increasing political uncertainty and – if this is not tackled – it may well have long-term economic consequences.
With the economic cycle maturing, higher nominal GDP growth and a favourable interest rate environment should support two years of double-digit corporate profit growth. Valuations are above average but still within ‘normal’ ranges. Where profits disappoint, stock dispersion has increased and at this point in the cycle we need to be vigilant for potentially ‘value destroying’ merger and acquisition activity. Throughout this year, we have increased cyclical exposure – notably through mining and financials – to complement our core recommendations for companies that generate strong free cash flows, as well as ‘disrupters’ of traditional industries. We aim to avoid companies with unsustainably high dividends, especially those, like utilities, that are closely correlated to bond yields.
