Please find a Global Outlook view kindly offered by Standard Life Investments
The world of low numbers
Structural issues facing the global economy are contributing to the current ‘world of low numbers’, in which we are experiencing low growth, low inflation, low interest rates and low bond yields. Cumulatively, these potentially add up to lower returns for financial assets over the medium term. However, against the structural backdrop, economic and political cycles can influence returns. Although a focus on policymaking is understandable, the internal dynamics of the corporate profits cycle warrant careful examination.
Cycles within cycles
Late spring and summer saw a number of economic disappointments that dented investor confidence. However, more recent figures have been a positive surprise. Inventory overhang and the effects of low commodity prices on investment appear to be diminishing, while better employment growth has generally supported retail sales. On balance, we continue to forecast a moderate improvement in global activity into 2017, supported by selective fiscal easing and healthier business sentiment.
During this period of slow global growth, one of the most significant outcomes was a lengthy profits recession, focused on commodities and finance (see Chart 1). It is uncommon for economies to suffer such an event without an actual economic recession appearing. On this occasion, recession was avoided thanks to a mixture of highly accommodative monetary policy, management decisions to constrain investment and wage growth, and the continued ability of companies to borrow in corporate debt markets. The good news is that the profits recession looks to be ending. Much of the downturn was caused by the collapse in commodity prices, while flatter yield curves also played a part by damaging profitability for parts of the financial services sector.
Analysts forecast global earnings growth of 12% for 2017; we expect to see downgrades to this figure but an overall positive outcome. The relationship between input and output prices, wages and productivity growth, changes in energy costs and the extent of any further rise in the US dollar will determine how positive. Headline inflation will rise during 2017 as the base effects from previous declines in energy prices fall away.
Will this have secondary effects on core inflation? How will businesses and households react to these trends? Will we see any return of pricing power, or workers gaining wage awards, especially in countries like Germany, Japan and the US where the economy is approaching full employment? How successful will companies be in driving forward productivity improvements in the next phase of the cycle, or will margins start to come under pressure?
As recent moves in the share price of financial companies have shown, even small changes in the yield curve can release value in over-sold sectors. Some central banks have realised the adverse effects of their previous policy of taking large parts of the yield curve into negative territory. This is why the Bank of Japan (BoJ) moved away from QQE, buying a set amount of government bonds and, instead, targeted yield curve management, including a steeper yield curve. Speculation that the European Central Bank (ECB) is discussing tapering may also have the same effect, via term premia.
Political hurdles ahead
The growing impact of political stress on financial markets is reflected in aggressive sterling depreciation related to the UK’s anticipated exit from the EU and the movements in the Mexican peso/US dollar exchange rate with political opinion polls in the US. Looking ahead, a stream of ballots in France, Germany, Italy and the Netherlands – to name the most important – could potentially spark political shocks. Unexpected outcomes can materially change cross-border flows. A prime example is the US presidential and congressional elections; we await important decisions on possible changes in the US’s trade policy and legislation affecting the repatriation of cash held by US companies overseas.
More broadly, we emphasise that populism remains robust in many countries. A particular issue for businesses is the growing pressure on governments to protect their populations from the adverse effects of globalisation, such as migration or ‘unfair trade’. For some years, we have looked for an upturn in global trade as a trigger to move into emerging market assets more heavily, but a variety of structural drivers appear to have broken the longstanding link between global trade and global growth (see Chart 2). More recently, the Transatlantic Trade and Investment Partnership (TTIP) between the EU and US, and the Trans-Pacific Partnership (TPP) have come up against significant political pressure from antiglobalisation campaigners. As the US election shows, the forces at play increase investor uncertainty dramatically, as multiple potential outcomes to political discussions and treaty negotiations become possible.
So, fiscal policy and structural reforms are imperative to determine whether countries can escape the low-inflation world. We see little progress on the latter, at least until the stream of elections are out of the way, but we are seeing progress on the fiscal outlook.
Policy path evolving
Central bankers have been stressing the role of fiscal policy to share the responsibility for the global growth outlook. Japan is an illustration of this shift; alongside the move away from QQE, the government has introduced a large fiscal stimulus to boost growth in 2017, while a debate has begun about whether an income policy might shock inflation expectations for households and companies. China is also allowing a more flexible approach; as well as depreciating the RMB steadily, the budget deficit is already about 4% and on course for 5% of GDP unless action is taken, well beyond the official 3% target.
Fiscal policy is more actively debated in many countries. We warn, however, that joined-up thinking on fiscal and monetary policy is limited to a few economies, including Canada, China, Japan and the UK. The degree of fiscal expansion in the US will depend on a complex debate between the various groupings in the new administration and congress. In Europe, there is a world of difference between the Maastricht rules being eased, say in France and Spain, and the new regime Italy has called for. On balance, the OECD suggests no more than a modest fiscal boost to growth in 2017 for its members, 2018 may be different. This is unfortunate as IMF analysis clearly points out the synergies from co-ordinated fiscal easing.
The recent jump in bond yields warrants examination against this backdrop. While debate about easier fiscal policy is one factor, signs of tighter labour markets and changes in monetary policy have been especially impactful. Our House View assumes that the US will raise interest rates in December and then slowly during 2017. We expect the Monetary Policy Committee to remain on hold unless the UK economy slows dramatically, and Japan to behave similarly unless the yen surges. The main area of uncertainty concerns the ECB. We still expect it to extend QE past March 2017, as core inflation is well away from target, but probably at a slower rate, which could appear as some form of tapering as it is running up against constraints of how many bonds to own.
The House View
Financial markets are at an interesting juncture. In recent weeks, there has been some rotation away from rather expensive dividend-yielding stocks towards more cyclical sectors, led by materials. The corporate earnings cycle will determine the timing of a move away from neutral positions in global equity. The House View remains underweight government bond markets, which are rather expensive against the backdrop of even modest shifts in monetary policy. Sustainable yield remains a key investment theme, with an emphasis on sustainability for those markets, credit or equity, where payout ratios are stretched. The House View remains underweight cash and overweight income-producing assets such as high yield bonds, emerging market debt and European REITS, on the grounds that the medium-term outlook will see slow global growth and stasis in official interest rates outside of the US. Hence, our duration position is broadly neutral.
UK assets deserve special mention in the wake of the EU referendum. Our funds have been light sterling versus the euro or dollar; the economy will go through an adjustment process over the next few years and the currency will act as a partial shock absorber while new institutional arrangements are created. Although UK stock markets have approached record highs in sterling terms, helped by the translation effect on profits from a lower pound, they remain rather lower in dollar or euro terms (see Chart 3). We have preferred corporate bonds to gilts, supported by the Bank of England’s new bond-buying programme. In light of the US election result, US equities are more attractive if the focus is on fiscal rather than trade policy in the new administration