Equity markets in the US, Japan and Asia made further progress in June although European equities gave back some of their previous gains. For sterling-based investors, dollar weakness meant global returns were marginally negative. The broadly based S&P 500 gained 11 to 2,423 – just shy of the month’s record high of 2,453. Profit taking in the tech sector after recent strong gains resulted in the Nasdaq falling 1%. The Nikkei 225 rose 382 to 20,033. Large, mid and small cap UK companies fell in June with the FTSE100 down 207 to 7,312. The FTSE Eurofirst lost 41 to 1,491 – just over 4% below its May high. US and UK bond yields have declined steadily in recent months with the 10 year gilt dipping below 1% in mid-June but the changing attitude of central banks towards normalising monetary policy caused a sharp spike in yields to 1.26% at the end of the month – the level at which they started 2017. Quantitative easing has kept bund yields within a tight range and they ended marginally higher at 0.46%.
Synchronised global growth should marginally exceed earlier forecasts with real GDP rising from 2.6% last year to 3.1% in 2017. 2.1% growth in the industrialised world compares with 4.4% for emerging economies with the latter dominated by China (6.6%) and India (7.5%) as well as a recovery in Russia (2%). During H1, expectations for US GDP have been lowered by the stalled Trump reflation package and for UK GDP by the addition of political uncertainty to the Brexit negotiations. Increased oil production pushed Brent crude back below $45 and helped offset slighter tighter labour markets. A growing number of central banks are talking openly about normalising monetary policy although only the Federal Reserve has raised interest rates – by another 25bp in June with a further small increase anticipated late this year. Of more significance for financial markets is the planned reduction in central bank balance sheets and the tapering of asset purchases. While political uncertainties have eased in the US, Germany and France, North Korea remains an unknown quantity and the isolation of Qatar has increased tensions in the Middle East. Bond investors continue to discount a disinflationary environment whereas equity markets have scaled new highs on expectations that higher nominal GDP will boost corporate profitability.
“Pump priming” by central banks in recent years raises concerns about the sustainability of growth in many regions – particularly China. Although the authorities have proved adept at deploying a range of tools to manage imbalances and maintain the credit impulse, there is unease about current debt levels. Exports have rebounded this year and industrial production and retail sales have remained strong. However, as regulatory tightening and higher real funding costs have weakened housing and investment, the likely response is policy easing in order to maintain 6%+ GDP growth. India’s two speed economy – with consumption increasing nearly 9% but investment less than 2% – was reflected in weaker than forecast Q1 GDP although we expect a gradual recovery from the demonetisation shock.
US economic activity will have recovered in Q2 despite recent data for retail sales, manufacturing production and housing starts failing to match some of the more optimistic expectations. Q2 GDP of around 3% would put the economy back on track to grow by 2.2% in 2017. While much of the reflation package hype has evaporated, we expect a modest fiscal boost to be agreed this autumn that will increase GDP to 2.6% next year. The fall in core inflation from 2.3% in January to 1.7% was unexpected given the low (4.3%) unemployment rate. As wage growth typically lags by six quarters, this may explain the Federal Reserve’s decision to continue normalising policy.
In contrast to the relatively stable prospects elsewhere, the outlook for the UK has become more uncertain following the self-inflicted loss of the Conservative party’s majority. In view of the problems this has created for the Brexit negotiations, the possibility of another election within 12 months cannot be ruled out. The economic news has become more mixed as – although manufacturing, consumer confidence and employment are strong – housing data, consumer spending and service sector confidence have softened. The squeeze on real disposable incomes will become apparent over the coming months and sterling weakness is already reflected in higher prices for many imported goods. The inflationary impact of sterling’s depreciation is being discounted as a “one-off” but something clearly has to give as consumers have less disposable income, wage growth is minimal and the savings rate is close to a record low. Against this backdrop, we expect a marginal decline in GDP to 1.7% this year and 1.5% in 2018 albeit consumers will largely determine the outcome. While hopes of a “softer” Brexit could boost business sentiment and extend the transition beyond 2019, the political situation increases the likelihood of a disorderly exit. After a volatile six months when sterling fell to $1.19, it ended H1 close to $1.29.
Eurozone economies have reported stronger than expected economic activity and, for the first time in a decade, real GDP growth is likely to be 2% in 2017. With lending accelerating, housing recovering and unemployment falling, governments are starting to scale back austerity measures. Although Ireland is on track to record the highest growth rate (4%) this year, Brexit poses a potential threat to movement of people and trade as much of the latter transitions through the UK. Chancellor Merkel is expected to win a fourth term in September’s German elections and President Macron’s election indicates new momentum for EU integration. The European Central Bank is now talking openly about normalising monetary policy and tapering asset purchases. Although the cyclical recovery is welcome, core inflation remains low so we expect the ECB to tread very carefully. Increased economic activity and inward capital flows have seen the euro rise over 8% to 1.14 during H1.
Eight years into the economic cycle with equity markets touching new highs, exceptional year-on-year returns and no sign of a correction, it is hardly surprising that many investors are feeling cautious. However, a combination of rising nominal GDP and relatively slow monetary tightening is a benign environment for risk assets and strong 2017 corporate earnings will provide additional support. While the tapering of central bank balance sheets requires close monitoring for signs of tighter credit conditions, equities can still make progress. A modest rise in bond yields should be expected and is likely to influence sector rotation.
The past year has seen above average sector rotation and this has provided opportunities for active investors. Falling bond yields in recent years have helped “growth” stocks out-perform “value” and, although the former are now looking expensive, valuations are still nowhere near “tech bubble” territory. If tapering by central banks results in a steeper yield curve, “value” stocks – typically represented in most markets by financials – could come back into favour. Analysts’ forecasts of a 14% increase in global corporate earnings puts the World index on a forward price/earnings ratio of 17x. This is above the longer-term average but by no means extreme. The US looks the most expensive and Asian/emerging markets the cheapest with Europe (including the UK) somewhere in the middle. Income-seeking investors will continue to be attracted by dividend yields and these are well supported by profits at this stage in the cycle.
This communication has been prepared for information purposes only and is not a solicitation, or an offer, to buy or sell any security. The information on which it is based is deemed to be reliable, but has not been independently verified nor do we guarantee accuracy or completeness. Investors should remember that the value of investments, and the income from them can go down as well as up, and that past performance is no guarantee of future returns.
