The global economy is firing on all cylinders, and this appears set to continue in 2018. With inflation still well below target, policymakers are keen to promote growth while gradually removing stimulus measures. The sharp increase in corporate profitability has supported strong gains in risk assets during 2017. The S&P 500 ended November up 72 at a new closing high of 2,647, while the Nikkei 225 rose 713 to 22,724. There was some profit taking in Europe, Asia and emerging markets, with the FTSE EuroFirst 300 down 34 at 1,519 and the FTSE 100 falling 166 to 7,326. US 10-year bond yields rose 5bp to 2.42% but UK and Eurozone yields were flat, at 1.3% and 0.38% respectively. Brent crude was well supported at $64, reflecting demand and OPEC’s agreement to extend production curbs.
Underlying economic conditions are the best in a decade. The geographic spread of growth is almost unprecedented and, with the possible exception of China, less dependent on debt than in many previous cycles. The main engines are the US, the Eurozone and China – all of which appear to be on course for another strong performance in 2018. US GDP in Q3 surprised on the upside and consumer and business confidence is robust despite the uncertainty surrounding tax cuts and health care reform. While President Trump may not have delivered so far on his promises, small businesses remain confident, with hiring plans and job openings at decade highs. Job security and rising wages usually bode well for consumption and GDP growth. However, with immigration and “offshoring” out of favour, low unemployment and, in particular, labour quality may prove challenging for companies and lead to wage pressures in the second half of next year. Although an increase in the participation rate and capital investment could help suppress labour costs for a while, US inflation is expected to reach 2% by the end of 2018.
The Eurozone is also experiencing synchronised growth across member states and sectors. Q3 GDP slowed marginally but overall financial conditions are very supportive. The Euro area ZEW Survey is in almost unprecedented territory, with strong readings from both current and projected economic components. As capital has flooded in and boosted growth, concerns that currency strength would derail the recovery have proved unfounded. The financial sector is now strong enough for banks to consider relaxing lending criteria and this, combined with increased capital expenditure in the private sector, will result in loan growth picking up. Unemployment is down by almost five million since the 2013 peak and, despite some pressures in Germany, the slack in France and Italy mean it could fall by another 18 million before reaching pre-financial crisis lows. The recovery looks balanced and self-sustaining, even if the rate of acceleration may be peaking.
Politics and Brexit uncertainty continue to dominate the UK economic outlook. Surveys suggest that consumers are less confident about the future and this, together with the squeeze on real disposable incomes from higher food and energy costs, is influencing expenditure on “large ticket” items. Interest rates returned to pre-EU referendum levels in November, when the Bank of England raised rates by 25bp to 50bp and suggested there would be further normalisation in 2018. However, low nominal rates should keep the economy out of recession. The possibility of a “hard” Brexit appears to be receding (however watch this space) and has helped sterling of late strengthen to $1.35.
The softening housing market in China is now spilling over into construction-related industries, and is likely to influence global commodity prices over the next 6-12 months. President Xi’s comments to the National Party Congress that houses are for living in and not for speculation suggest that the policy squeeze will continue and mainly impact the “old” economy. Meanwhile, the “new” economy (the service sector and light manufacturing) is expected to grow strongly and under-pin above average GDP growth. The robustness of the latter also influences the outlook for Japan, where the upturn in global trade is boosting exports – particularly technology products and autos. Preparations for the 2020 Tokyo Olympics will have maximum impact on GDP in 2018, while consumer spending – normally a structural challenge given the gradual decline in pensioners’ purchasing power – will benefit from front- loaded demand ahead of the proposed consumption tax increase in 2019. Above trend GDP growth will result in a strong upturn in corporate profitability.
The economic cycle is maturing and financial conditions are expected to tighten next year as central banks phase out quantitative easing and normalise interest rates. However, in our view the business cycle has further to run and we see little sign of the excesses associated with an over-extended bull market. Increased corporate leverage is one of the few warning signals but other indicators are typical of the cycle’s reflationary stage. These include the rise in global capital expenditure that usually accompanies improving corporate confidence and cash flow. Similarly, the yield curve tends to flatten with the removal of excessive monetary accommodation, although the unprecedented scale of central bank intervention has made this cycle more difficult to read. Other indicators are nowhere near historic extremes and – with little sign of inflation picking up, very low credit spreads and valuations only slightly above long-term averages – there is scope for equities to make further progress in 2018. While financials may find conditions more challenging as short-term rates rise and structural issues remain for the business models of certain consumer sectors, cyclical and resource companies are experiencing a revival. On 16% forecast earnings growth, global equities are on a prospective P/E multiple of 17x and a dividend yield of 2.4%. Eurozone and Japanese equities appear better value, but we are not ruling out another strong year for the US.
