Financial markets had a volatile first quarter, with equities rising sharply in January on expectations of synchronised global growth and another year of exceptional corporate profitability. The technical correction triggered in early February by US wage data was then compounded by a further period of weakness in March on fears that US protectionist measures might lead to a global trade war. One theme linking all these was inflation which – at least in the US – appears to be rising. Another 25bp US interest rate rise to 1.75% at the end of March was not entirely coincidental, with more in the pipeline and a flattening yield curve.
Although the S&P 500 only fell 33 to 2,640 over the quarter after its 2,872 record high in late January, the Nikkei 225 and FTSEurofirst closed down 5%, losing 1,310 to 21,454 and 77 to 1,452 respectively. Sterling’s 4% appreciation against the dollar impacted the FTSE 100, which fell 631 to 7,056 having reached 7,778 in early January. The more domestically orientated UK mid and small cap companies out-performed. Total returns (including income) from bonds were marginally positive.
Following 3% global growth in Q1, we expect GDP to pick up again to around 3.7% over the remainder of the year. In emerging economies, growth is likely to be 4.8% v 2.4% in industrialised countries – both marginally higher than 2017. Despite the recent Chinese National People’s Congress announcing a lower growth target, year-to-date activity has surprised on the upside with industrial production, fixed asset investment and exports all accelerating. The March official purchasing manager indices suggested these trends will continue, so 6.6% GDP should be achievable v 6.9% last year. However, the risk of an escalation in the China-US trade confrontation should not be under-estimated, as in reality the $375bn merchandise deficit cannot be cut by anything close to President Trump’s $100bn target. For example, although China purchased around 20% of US oil exports in 2017 and could absorb more, this would not resolve the merchandise or the more contentious intellectual property deficits. The best guesstimate is that the measures announced so far will reduce China’s GDP by less than 0.2%. Of the other key emerging economy contributors, India continues to grow more rapidly than China, while Brazil and Russia are accelerating modestly. Given their sensitivity to trade flows, these markets have held up relatively well and benefited from dollar weakness.
In industrialised economies, the US and Eurozone head the league table. Recent US surveys of retail sales, housing transactions and manufacturing suggest the pace of expansion has eased and Q1 GDP will be close to 2% v estimates of 3%. This is likely to be a temporary lull as consumption and business investment improve and government spending increases. Although jobs growth has slowed, it is still above the replacement rate and unemployment could fall to 3.5% by the end of the year. Consumer price inflation will rise modestly – companies are reporting raw material price pressures and the oil price at $68 is only marginally below its six month high. Wage growth is a major concern, with hiring intentions and tight labour markets indicating it could exceed 3% by the end of the year. It is therefore hardly surprising that, while continuing the gradual approach to policy normalisation, the Federal Open Markets Committee and the new Federal Reserve Chairman see interest rates at 2.25% by year-end and over 3% in 2019, which would close the negative real interest rate gap. Tighter monetary policy may also be needed to help offset the record fiscal deficit, which is projected to be almost 7% of GDP next year – well over double that of other G7 economies. Against this backdrop, dollar weakness is not unexpected.
Eurozone growth is steady at around 2.4% and, assuming there is no significant fiscal boost, the risks now appear tilted on the downside. Germany was impacted by adverse weather in Q1 and confidence indicators have eased in the export-orientated manufacturing sector. By contrast, business confidence in France is the highest for some time and, despite marginally weaker exports and tourism suffering from the problems in Catalonia, Spain remains on track for 3% GDP growth this year – second only to Ireland, where the economy is expanding at close to 4%. Although Eurozone jobs growth is improving and unemployment is falling, the European Central Bank is unlikely to start raising interest rates for another 12 months.
Japan and the UK lag their G7 counterparts by a substantial margin. The Bank of Japan’s Tankan survey of large businesses showed confidence easing as rising raw material prices, tight labour markets, a strong yen and fears of a global trade war dent the otherwise stable outlook. While rising exports, a recovery in business investment and Olympics-related demand should mean GDP growth of 1.6% this year, this is unlikely to persuade the BoJ to unwind monetary stimulus.
The outlook for the UK has improved in recent weeks as, to the relief of the corporate sector, a Brexit transition phase is close to agreement, boosting sterling to $1.40. Although major challenges remain and markets may be over-optimistic about the eventual outcome, 1.6% GDP growth is still expected this year. Pressure on real incomes should ease as inflation normalises and wage growth picks up, but Brexit uncertainty will continue to impact business investment and exports. Despite sub-trend growth, the Bank of England still expects interest rates to rise earlier and to a greater extent than previously anticipated. However, as the UK economy is not strong enough and too highly indebted to match US rate rises, we expect 25bp increases in Q2 and Q4 leaving rates at 1% by year-end.
The global corporate profits outlook remains buoyant, with growth of 15% expected this year. Although over the past month estimates have been shaved for Japan (7%) and the Eurozone (10%), they have increased for the US (19%) and UK (8%). The upgrades are energy, materials and financials – but not technology – with downgrades mostly confined to the consumer, utility and telecom sectors. In the absence of a deep recession, which we do not anticipate, valuations now look interesting, especially in the Eurozone (14x) and UK (13x), where they are back to longer-term averages. With 15% earnings growth and valuations of 12x, emerging markets appear particularly attractive. However, rising interest rates and bond yields usually lead to a reappraisal of discounted cash flows and earnings, a general market de-rating – as share prices lag higher profits – and also sector/style rotation. This suggests the potential upside may be accompanied by a change in leadership and a move from growth to value.
