The global economy remains on track for another year of strong GDP growth – currently estimated to be 3.4%. After temporary influences dampened growth in Q1, the pace has picked up in Q2 although marginally weaker business surveys suggest momentum, particularly outside the US, may have peaked. This appears to reflect a number of factors including a peak in the capital expenditure cycle, capacity constraints, higher oil prices and tighter financial conditions. Despite surprising on the downside recently, inflation is likely to move towards central bank targets as the year progresses. While the Federal Reserve has signalled further rate rises, other central banks appear in no rush to follow. The differential between advanced and emerging economy growth has stabilised giving the weakening US dollar some respite from the escalating twin deficits.
Tightening financial conditions have resulted in higher volatility and a lower correlation to economic strength. As US short rates are normalised, financial markets have discounted rising inflation with the US Treasury 10 year yield recently pushing through 3% and potentially re-establishing the relationship with nominal GDP growth. Elsewhere, bond market reaction has been more muted with the European Central Bank not expected to end asset purchases before December or increase interest rates until 2019, the Bank of Japan abandoning any explicit reference to when its inflation target could be reached and the Bank of England delaying the next rate rise until at least August reflecting Brexit uncertainty and disappointing economic data.
After a roller-coaster start to 2018, global equity returns for sterling-based investors are back in positive territory. However, regional markets have decoupled so, while the S&P 500 rose 60 points in May to 2,733 and the FTSE 100 was up 100 to 7,788, the Nikkei 225 fell 327 to 22,437 and the FTSEurofirst 9 to 1,538. Strong emerging market gains earlier in the year have been eroded by profit taking and the stronger dollar. As dollar liabilities have increased in absolute terms during this cycle, a stronger currency and/or higher interest rates will increase the cost of servicing debt. However, concerns over creditworthiness appear to be exaggerated given foreign direct investment now targets projects with long time horizons. This has reduced the flow of “hot money” so Argentina and Turkey are currently the only emerging economies heavily dependent on external financing.
The news on corporate profits continues to be positive. Expectations increased during 2017 and results exceeded estimates by a significant margin – notably in the US where the year-on-year increase was 25%. Globally, the uplift in energy profits was exceptional but sectors sensitive to the economic cycle such as materials, IT, Industrials and Financials also reported solid rises. Consumer, healthcare and utilities lagged while the prospect of higher interest rates and tightening credit proved challenging for the real estate sector. As Q1 was exceptional, upward revisions to estimates, albeit more modest, are encouraging and indicate that – excluding energy – profits could rise by 15%. Materials and energy still have strong growth momentum but other cyclical sectors will slow reflecting the view that the economic cycle is maturing and President Trump’s tax cuts have “borrowed” future growth.
The maturity of the cycle was a key topic before markets entered their tenth year of expansion. The post-financial crisis recovery has been long and slow and, even though time may not be a helpful yardstick of longevity, we can detect few signs of market excess. In fact, many advanced economies are facing the same structural challenges of ageing demographics and unfunded promises on healthcare and pensions. These have been manifested by rising “populism” and geopolitical tensions – most recently in Italy. Given that Italy’s 130% debt/GDP ratio compares with a Eurozone average of around 87%, some form of compromise appears the most likely outcome but meanwhile the era of narrowing risk premiums has almost certainly come to an end. While these challenges will not deter central banks from withdrawing quantitative easing and normalising rates, debt servicing is a delicate balancing act and interest rate peaks are likely to be lower than in previous cycles.
The US and Chinese economies continue to be a significant influence on global growth and both are growing strongly. Despite a tightening phase in the credit cycle, the latest data indicates 2018 GDP growth in China will again exceed 6.5% while US GDP should increase from 2.3% last year to 2.9% as the economy benefits from the fiscal boost. Elsewhere, business surveys point to healthy rather than exceptional growth. Softening global demand, bad weather and idiosyncratic factors such as the timing of Easter have resulted in small downward revisions to GDP estimates for the Eurozone (2.2%) and Japan (0.9%). Within the Eurozone, Ireland remains a highlight with private consumption expected to grow 2.9%, strong employment and well below average levels of debt but political developments in Italy are likely to affect business sentiment and jeopardise projected GDP growth of 1.2%. In the UK, the directionless Brexit process has impacted business investment, consumer spending and house prices reducing estimated GDP to 1.2%. Although wage growth and falling inflation should provide some short-term respite, political infighting and lack of progress on transition could mean consumers decide to rebuild savings instead of spending increased disposal income.
After a very strong 2017, slowing global activity is not entirely surprising but trade and geopolitical tensions are at the forefront of investors’ minds. Markets are interpreting the US administration’s latest tariff moves as brinkmanship that will increase volatility rather than threaten globalisation. We can see few indications of an abrupt end to the economic and corporate profit cycles so remain broadly positive on risk assets while recognising that slower sales growth and higher interest rates, inflation and wages are likely to constrain profits and result in more modest share price increases. However, the improvement in corporate earnings has helped lower valuations with global equities now on a prospective multiple of 14.9x – at the bottom of the 12 month range and just under the 20 year average. The US remains expensive in absolute terms reflecting its higher growth potential and a bias towards growth industries. With globalisation of the supply chain and technology challenging traditional business models – especially in areas like consumer staples – our stock selection continues to focus on the potential for capital growth and sustainability of dividends.
