The flurry of populist policy initiatives following President Trump’s inauguration caught financial markets off guard and heightened uncertainty in key economic areas – including trade and taxation. Although US markets made further modest gains in January – the S&P 500 rose 40 to 2,278 – European and Japanese indices lost some momentum despite supportive economic data. The FTSEurofirst 300 was 7 lower at 1,421 and the Nikkei 225 fell 73 to 19,041. The FTSE100 was down 44 at 7,099. After a strong run, the dollar fell 2% to $1.26. Broad adherence to the OPEC production agreement helped stabilise the Brent crude price at $57. The acceleration in global growth that started in mid-2016 is continuing with many consumer and business sentiment surveys at multi-year highs. GDP estimates are now being revised up marginally to 2.8% in 2017 and 3.2% in 2018 to reflect the outlook for manufacturing in the advanced economies.
While global trade has picked up, so far this is mainly due to higher commodity prices rather than increased volumes so estimates for emerging markets growth, though high in absolute terms at 4.2%, are unchanged. Higher growth has been accompanied by a broad-based rise in inflation expectations to around 2% in 2017, again predominately in advanced economies. Central banks are assuming these pressures are the result of temporary factors – recovering commodity prices and the rise in inflation from exceptionally low levels – and that neither will be repeated. However, wage growth will need to be monitored closely as at around 5% unemployment is already very low in the US and UK and is even falling in Europe where it has been stubbornly high since the financial crisis. The changing inflation outlook means further monetary easing is unlikely this year. High debt levels and the lagged impact of disinflationary influences suggest central banks are likely to err on the side of caution on interest rate increases given that inflation in most economies is expected to rise towards 2% target levels.
The European Central Bank and Bank of Japan will remain committed to quantitative easing – the latter by targeting zero yields on 10year government bonds – but asset purchase programmes will diminish as policy emphasis shifts from monetary to fiscal measures. The Federal Reserve has already started to normalise rates and its gradual approach means markets are discounting only two or three 25bp increases in 2017. The UK economy’s unexpected resilience combined with the expected step change as imported goods inflation feeds through to prices means the Bank of England may find it increasingly difficult to ignore a spike in CPI later this year.
US nationalism has dominated the headlines in recent weeks but growth prospects in China have upset the global equilibrium several times in recent years and could do so again. The transition from the “old” to “new” economic model and from exports to consumption continues with the latter representing 65% of GDP growth in 2016 and 52% of the service sector. Growth is likely to slow marginally in 2017 to 6.5% as the authorities attempt to maintain economic stability by limiting property speculation while the recent unexpected interest rate rise suggests that last year’s ultra-accommodative monetary policy is over for the time being.
The proposed US border tax and increasing trade friction are obvious risks to Chinese exports but a stronger dollar is also a potential threat to financial stability if capital outflows accelerate and put further pressure on the RMB. Global protectionism would adversely impact Asia – particularly economies running sizeable deficits in areas like IT, household appliances and vehicle parts where the US believes it has sufficient competitive advantage to manufacture domestically. Those perceived most vulnerable are Korea and Taiwan where it is estimated that a 15% border tax would reduce the latter’s GDP by 0.75% and halve annual GDP growth. Elsewhere, GDP growth is decelerating temporarily in India following the demonetisation of high denomination bank notes although Russia is expected to emerge from a two-year recession in time for the 2018 presidential election.
The performance differential between bonds and equities has increased significantly over the last six months as markets focussed on a ‘reflation trade’. Although shorter-dated bonds still have diversification benefits, they are unlikely to offer strong absolute returns in 2017. After rising sharply, yields on US 10 year bonds have paused just below 2.5% but surprisingly robust UK growth and higher inflation saw gilt yields rise by 18bp to 1.42% in January. Having moved into negative territory last summer, Eurozone yields have also risen but at 0.38% remain severely constrained by ECB policy. Political uncertainty in France has seen peripheral spreads widen against Germany. The differential between US and European yields will continue on economic grounds but there are other factors at play in the UK including demand from overseas and pension funds and the roll-forward of gilts held under the quantitative easing asset purchase programme. Demand from retail investors for index-linked gilts has pushed valuations close to historic extremes and on a breakeven basis imply that RPI will average 3.5% or more over the next 10 years. As Brexit negotiations could damage consumer confidence sufficiently to cause a ‘cliff-edge’ collapse in economic activity and inflation, the outlook for UK bond yields remains more uncertain than usual.
The most encouraging news is on the corporate front where global profits are rebounding following the downturn from mid-2014 until early 2016. The drag from energy and mining sectors has reversed and increased economic activity will boost revenues. Financials are major beneficiaries of the current environment as stronger growth leads to higher incomes, confidence and loan demand. There is also potential for higher margins on lending as interest rates rise and the differential between short and long-term rates widens. Current estimates are for global earnings per share to increase 9% this year but for the first time in a while we could see upward revisions as the year progresses.
Global growth tailwinds should continue to support risk assets although the unpredictability of the Trump presidency may well temper investor enthusiasm. If the new administration can deliver a viable fiscal stimulus and avoid a major trade confrontation, GDP and corporate profits could surprise on the upside – and not just in the US. Asia remains most vulnerable to a retreat on globalisation given the region’s high debt levels and emphasis on low margin volume business. Although political distractions are likely to increase in Europe with the UK triggering Article 50 in March, the French presidential election in May and German federal elections in September, companies have a good record of adapting to changing circumstances. A period of consolidation for equity markets would be healthy and enable earnings to catch up with valuations.
