Robust economic growth, low inflation and an accomodative monetary policy supported a strong momentum rally in risk assets in January. The S&P 500 – spurred on by US tax cuts – rose 150 points to 2,823, while other equity markets recorded more modest gains, with the Nikkei 225 up 333 at 23,098 and the FTSEurofirst up 24 at 1,554. The 5% appreciation in sterling to $1.42 impacted the FTSE 100, which fell 154 to 7,533. Tightening labour markets, higher commodity prices – Brent crude rose 5% to $70 – and the unwinding of quantitative easing by central banks resulted in higher US and UK Treasury yields.
Given the strength of the global economy, we now expect GDP growth of 3.4% – the highest rate since 2010 and 0.6% above the 10-year average. Growth of 2.4% in the industrialised economies is also strong by recent standards but is eclipsed by 4.7% from Asia and emerging markets. The trend is broadly based across economies and sectors, with the lowest regional variation since 1990. Real growth in global industrial production is at its highest since 2011, with trade and investment supporting the upturn. Forward-looking surveys, such as global purchasing manager indices, suggest momentum will continue to build this year and could peak at 3.7% in Q4. This compares with 4.2% at the top of the 2001-07 cycle. A similar figure is unlikely as emerging economies mature and account for a larger proportion of the global economy, but peak growth of 4% appears achievable.
China and India will continue to grow strongly. China will lose some momentum, with GDP falling from 6.8% to 6.5% as fiscal stimulus measures are withdrawn and policy transitions towards sustainability. However, India should accelerate as the negative impact of demonetization and tax standardisation fades, and private investment and rural demand picks up. US GDP is expected to accelerate to 2.7%, reflecting tax-related stimulus and higher government spending to repair hurricane damage. Consumption is the main growth engine, and improving confidence is driving down the savings ratio. The rise in housing investment after relative weakness last summer, higher investment in business equipment and expanding manufacturing payrolls suggest that unemployment is likely to fall below 4%. Year-on-year growth in average hourly earnings has increased to 2.9% and core inflation is 1.8% and rising, but neither will derail the Federal Reserve’s gradual approach to normalising interest rates. Markets are interpreting this as three further hikes this year from 1.5% to 2.25%.
Japan and the Eurozone are also beneficiaries of the global cyclical upturn. The Japanese economy has been boosted by exports, a recovery in business investment, the 2020 Tokyo Olympics and higher consumer spending before the anticipated tax rise in 2019. GDP growth of 1.8% is well above the recent average, corporate profits are rising strongly and there is some wage growth. The structural challenge of ageing demographics and negligible immigration, very low (2.5%) nominal GDP growth and Japan’s dependency on imported energy mean that from an investment perspective the attraction is currently more tactical than strategic. The Eurozone will also benefit from accelerating exports, as well as improving confidence. GDP is expected to be 2.5% but recent surveys are consistent with annualised growth of nearer 3%. This is broad-based, with Germany, Spain and more recently France making significant contributions, while exports should help Ireland achieve 4.4% and top the growth league table. Greece is expected to emerge from the International Monetary Fund’s rehabilitation programme in August, albeit growth will be low. The laggard is Italy, where business investment is key to achieving 1.6% GDP, while the outcome of elections in early March is far from certain. The cyclical upturn has strengthened the euro but the greatest challenges are the tapering of central bank asset purchases, a return to positive interest rates and addressing broader structural challenges such as fiscal union.
Although UK economic growth was resilient last year, our concern has always been 2018 and beyond. GDP estimates of 1.6% are well below the long-term trend reflecting slowing business investment and the impact of rising prices and Brexit uncertainties on consumer confidence. Manufacturers have experienced a boost from currency weakness with a healthy upturn in orders, production, exports and hiring intentions. However, as EU treaties cover 60% of UK trade, exports could face higher barriers and this is affecting investment plans despite the fall in spare capacity and ultra-low financing costs. Consumer confidence – especially among “middle income” earners – may also be fading, judging by the slowdown in year-on-year retail sales volumes, mortgage approvals, foreign trips and car sales. Inflation will ease later this year and employment remains strong, so recession should be avoided. The increase in public sector pay combined with signs of recruitment problems give the Bank of England an opportunity to raise interest rates again this year before pausing to await the Brexit outcome. We expect a transition arrangement to be in place by March 2019 but increasingly open rebellion within the Conservative Party and Labour poll gains suggest this is by no means certain.
Corporate profitability surprised on the upside last year and an increase of around 6% globally in nominal GDP expectations (4% for industrialised economies) means 2018 earnings should grow over 10% – possibly slightly more in Asia and emerging markets. US earnings are strong and likely to be boosted by tax cuts, although the impact of repatriated earnings will depend on how these are deployed: this could be higher investment, wage increases or taking on more staff but an alterative scenario is returning cash to shareholders in the form of buybacks and dividends, as happened after the 2004 Homeland Act. We continue to prefer European and Japanese equities and have recently reduced our UK exposure in favour of Asia and emerging markets. Technology and financials still offer the most scope for earnings growth while telecoms, utilities and REITs face structural challenges and higher bond yields.
We see upside risks to economic growth, inflation and monetary policy tightening. Strong asset prices and buoyant investor sentiment suggest some of the good news is already priced in and a period of consolidation is overdue. The current cycle is relatively extended by historic standards, but expansion is weak and industrial production has yet to reach pre-financial crisis levels. So, although the business cycle is maturing, in our view there is further to go.
