A Whistle-stop Tour of the Economic Landscape
- Date: 03/09/2018
- Source: Agenda Magazine (Isle of Man)
A review of the backdrop
During 2017 investors enjoyed several positive surprises. Economic growth was stronger than consensus forecast at the start of the year, inflation was notably lower than expected in most major economies (with notable exceptions like the UK) and corporate profitability recovered from the weakness seen the previous year. All these meant that investors’ expectation at the start of 2018 was that growth would accelerate further over the course of this year.
The reality, however, has fallen short of those expectations. Rather than a pick-up in growth rates in 2018, the momentum of economic growth has slowed across the major developed economies. The notable exception is the US which is being supported by a temporary fiscal boost from tax cuts and increased government spending.
In addition to a broad based slowdown from the growth rate achieved in the second half of 2017, the global economy’s performance since the turn of the year has been uneven. Indeed, economic releases in recent months have demonstrated the extent of the ongoing divergence in growth momentum across major economies. For instance, data for the second quarter showed that the Euro-zone’s economy expanded by 0.3% over the previous quarter, the weakest pace in two years. In contrast, the US reported a growth rate of 4.1% for the second quarter of 2018, the fastest pace of growth since the third quarter of 2014.
An assessment of the outlook
At this point, the evidence from a range of important leading economic indicators suggests a modest outlook for global economic growth over the next few quarters. In the US where growth has been most resilient, the Q2 2018 growth rate is unsustainable and growth should moderate in the months ahead. In the other major developed economies (including the UK), the outlook is less constructive, with signs of easing growth momentum.
Beyond shorter term dynamics, the medium term global economic outlook has become clouded by the risk of a trade war between the US and its major trading partners. At this point, it remains unclear how the trade disputes will pan out but the risk to the global economy and financial markets from an outright trade war could be significant. This introduces a negative skew to the range of possible outcomes for the global economy in the months and years ahead.
Implications for investors
In recent months equity markets have been caught between two powerful forces. On the positive side, investor sentiment has been buoyed by strong corporate earnings, particularly in the US, where companies have benefited from recent cuts in corporate tax rates. On the negative side, markets have had to contend with the combination of a rise in political risk and ongoing uncertainty about the potential fallout from US trade policy.
Looking to the rest of the year and beyond, the risks are quite finely balanced. Despite providing short term support, the strength in recent earnings growth is not sustainable and the likely decline in earnings growth rates should begin to weigh on expectations for 2019. This could prevent equity markets from making much headway over the next few months.
Strong growth, low unemployment rate and rising inflation mean that the US Federal Reserve is likely to maintain its course of interest rate hikes. Further increases in US interest rates will drive further flattening in the yield curve. The tone of monetary policy has also changed outside the US, with the Bank of England recently raising interest rates while the European Central Bank has announced plans to end quantitative easing. This combination is negative for bonds in general. However, safe haven demand, driven by concerns about the economic impact of a potential trade war and fears about spill over effects from the ongoing crisis in Turkey should provide some support. We remain cautious on corporate bonds across the credit spectrum on the basis that credit spreads remain tight.
Over the years, we have fine-tuned our approach to alternative investments and enhanced the performance of our clients’ portfolios as a result. In recent months we have benefited from the performance of the listed PPP/PFI Infrastructure sector which has been boosted by a series of secondary market transactions and a takeover approach for John Laing Infrastructure Fund. We believe that fundamentals also remain strong for a number of other sectors, such as digital infrastructure, that exhibit low correlation with traditional assets.
Finally, in the currency markets the key trend looks set to remain that of US Dollar strength against other major currencies as the USD continues to enjoy yield support. Focusing on sterling, the recent slide in the GBP/USD rate has been driven by ongoing Brexit-related uncertainties as investors assess the risk of a no-deal exit from the EU.
In the short term, the weight of bearish investor positioning could push GBP much lower than what could be justified on fundamental grounds. Nevertheless, an actual no-deal outcome would most likely result in a far more protracted sterling sell-off, likely pushing sterling below $1.20. On the other hand, sterling’s sensitivity to Brexit news flow is such that any news of a UK/EU agreement could trigger a sharp relief rally which would be further fuelled by short covering as bearish positions are unwound. It looks set to be a long summer for sterling!
Chief Investment Officer
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