For the first time since the financial crisis in 2008, the global economy enjoyed a period of synchronised growth in 2017. Leading indicators suggest that this momentum should continue in 2018. The improvement in economic conditions has driven company profits higher, which in turn has supported strong gains in equity markets during 2017, with many equity indices closing the year at, or very close to, their all-time high. The S&P 500 rose 31 points in December to close at 2673 and FTSEurofirst gained a similar amount in percentage terms adding 22 points to 1529. Asia and emerging markets produced even greater gains and FTSE 100 topped the league table rising 387 points to a new all-time closing high of 7687. The Japanese Nikkei 225 was the only major market to fall on the month, down 54 points to 22764. Sterling ended the year at $1.35 and €1.12. Compliance with OPEC quotas continued to support the oil price, with Brent crude up again in December to $68.
The underlying economic conditions are the best in a decade. The breadth of growth is almost unprecedented and less debt dependent than most previous cycles, the exception perhaps being China. The main engines of growth are the US, Eurozone and China, all of which look set for another strong performance in 2018. In the closing days of 2017, President Trump succeeded in delivering on one of his election pledges – namely the biggest overhaul of US taxation in 30 years. Under the new system, the headline rate of corporation tax will fall from 35% to 21%. US companies that have kept cash overseas will be able to remit this to the US and see it taxed at a beneficial rate of 15.5%. It is anticipated that the changes to the tax rates could add 6-8% to company profits in 2018. For the economy as a whole, employment growth remains strong and wages are rising above the prevailing rate of inflation. As a result, consumer confidence remains buoyant, while business optimism has received a boost from the tax reforms. As expected, the US Federal Reserve raised interest rates by a quarter of one percent in December, the third such rise in 2017. Official forecasts point to another three quarter point increases in 2018 followed by two more in 2019. This would take official borrowing costs to 2.5%, still well below levels that prevailed before the financial crisis.
The Eurozone is also enjoying resurgence in growth across all member states and sectors. Overall financial conditions remain very supportive with the European Central Bank programme of quantitative easing (bond purchases) continuing into 2018. The quantity of bonds purchased will reduce from €60 billion per month to €30 per month from January, but the improvement in economic health justifies the reduction in the pace of financial stimulus. The level of unemployment in the Eurozone is falling, but still remains high in absolute terms at around 9%. With economic recovery set to continue, the level of unemployment has considerable scope to reduce further. Markets largely shrugged off a series of potentially destabilising political events during 2017, notably the French and German elections, with a revival of “extreme” party popularity. This is testimony to the more robust economic environment currently being experienced.
Politics and Brexit uncertainty have begun to affect the UK economy. Although surveys suggest that consumers remain confident about their current conditions, they are less so about the future. The squeeze on real disposable incomes from higher food and energy costs is influencing larger ticket expenditure and with the most recent reading of CPI inflation hitting 3.1%, this could continue well into 2018. In contrast to mainland Europe, growth forecasts for the UK have steadily reduced in recent months. From enjoying the fastest economic growth of the major G7 economies prior to the EU referendum in June 2016, the UK is at now at the bottom of the pack. Much depends on the Brexit negotiations and the fate of the pound. A “breakthrough” by Theresa May and her negotiating team means that the next phase of talks can commence, but many of the key issues remain unresolved. The pound has been caught between a strengthening euro and a weakening dollar in 2017, but may carve more of its own path this year as we inch closer to agreeing the conditions around the transition agreement on leaving the European Union.
As ever, China remains an enigma. The official growth target of 6.5% is being met despite the ongoing transition from an export and infrastructure led economy to a more service orientated one. Managing the growth of credit, especially in the regions, remains a challenge for the authorities, but China will undoubtedly continue to increase in influence and importance over the next few years, both as a consumer of commodities and as an exporter of finished goods. The Japanese economy meanwhile is benefiting from the improvement in global trade and demand, particularly in technology related products. Industry 4.0, the so-called fourth industrial revolution driven by robotics and automation, is particularly beneficial for many of the Japanese companies who lead the field in these new areas.
Nine years after the financial crisis, the economic cycle is maturing. Financial conditions will likely tighten over the coming year as central banks phase out quantitative easing and move to normalise interest rates. However we believe the business cycle has further to run and see few signs of traditional excess associated with an over-extended bull market. The newly announced cuts in US tax rates should help the world’s largest economy deliver another year of decent growth. An increase in corporate leverage is one of the few warning signs but other indicators are typical of this reflationary stage of the cycle including a pickup in global capital expenditure, which usually accompanies improved corporate confidence and cash flow. Other indicators are nowhere near historic extremes and with little sign of a pickup in inflation, very low credit spreads and equity valuations only slightly above long-term averages, equities can make further progress in 2018. Financials may find conditions a little more challenging as short rates rise and the business models of certain consumer sectors remain structurally challenged, but cyclical and resource companies are enjoying a revival. Global equities trade on a 16x forward P/E multiple on forecast 10% earnings growth and a dividend yield of 2.4%. The European and Japanese equity markets look better value than average but we wouldn’t rule out another strong year for the US.
