Report completed on September 19th, 2016
Better growth despite a complex environment
Uncertainty stemming from the UK’s vote to leave the European Union has not yet had an impact on the economy. The referendum’s consequences may well remain domestic, but the referendum itself has served to reveal a complex political environment. Nonetheless, the latest economic data indicate a slight upturn in global growth, notably due to the US inventory rundown coming to a close, and stabilising growth in both Brazil and Russia. Across the globe, prevailing trends are expected to remain: Eurozone improvement is ongoing and the Chinese government is steering its economy. Disappointment over current global growth levels needs putting back into perspective, with the 2003-2008 period being an exception rather than the rule. Therefore, although the growth slowdown is structural, we believe hitting a recession is unlikely in the next two to three years. The recent backdrop has led central banks to adopt very loose monetary policies: had the Fed implemented the Taylor rule, interest rates would already have been raised. This more cautious approach stems from the attention it is now paying to the bigger picture. That said, the Fed is likely to adopt a rate-hike cycle in forthcoming months which will weigh on the performance of the least-risky bonds. In contrast, against an improving macroeconomic backdrop, Eurozone corporate results forecasts have been upgraded, which should buoy the region’s stock markets.
Brexit: limited economic impact, but a complex political environment is revealed
Brexit: limited economic impact on global growth…
It is still too early to judge the full extent of Brexit’s economic and political aftermath. We can see, however, that the UK referendum has affected neither global financial conditions (Figure 1) nor Eurozone confidence levels, both of which could have been key vectors of potential short-term shockwaves. In the UK, the BoE’s action was instrumental in limiting the immediate impact, but long-term growth is likely to suffer. Moreover, a great deal of uncertainty hangs over the nature of the UK’s relationship with the European Union. Given monetary policy’s future direction as well as pressure from a significant current account deficit, sterling could slide further.
…but a complex political environment is revealed
Aside from the economic impact of the UK’s vote to leave the European Union, it has served to reveal a complex political backdrop. The popularity of the US presidential candidates Donald Trump and Bernie Sanders aptly demonstrates that the question is not just a straightforward matter of economic climate: in both the US and the UK, the unemployment rate has returned to the lows registered during the previous cycle (Figure 2). The recent crisis has no doubt worsened a feeling of abandonment felt by certain sections of society in developed countries, especially amongst the middle classes who have seen their incomes stagnate over the last two decades. As the UK referendum has demonstrated, financial markets find the political dimension a difficult one to grasp. As such, Italy’s referendum and the US presidential elections are potential sources of volatility in the months ahead, although political uncertainty is not a systematic trigger for market volatility (Figure 3).
Main deadlines for the UK’s exit from the European Union
Little cause for economic concern outside the United Kingdom
The eurozone upturn continues
The Brexit vote has not yet knocked Eurozone confidence and the ECB’s particularly accommodative monetary policy stance is still feeding into the economy (Figure 4). In addition, this year’s fiscal policy is expected to remain on the expansionary side. Inflation remains weak but should recover as oil price related base effects become more positive.
US growth is set to gain pace following a mid-cycle slowdown
Disappointment over US growth can in large part be explained by lower investment spending in the extractive industry as well as lower stockpiling (Figure 5). Given that both trends are tapering off and that the housing sector is still improving, growth should pick up, enabling unemployment to pursue its decline.
Japanese authorities have opened the door to new stimulus measures
Japanese growth remains lacklustre and the strong yen has halted a rise in inflation (Figure 6). The labour market is still tightening, but wage inflation remains weak. Against this backdrop, the Japanese central bank remains very proactive and the government has announced stimulus that now needs voting in by parliament.
China’s government still steering the economy
Since the end of 2015, the government has buoyed its economy by stimulating investment and credit expansion (Figure 7). Reduced support in recent months has weighed on investment but recent data indicate a stabilisation. The reduced level of support is being felt in the struggling building sector and if growth surprises to the downside, then the Chinese government may well undertake new measures to achieve its 6.5%-7.0% growth target for this year.
The emerging markets slowdown is coming to an end
Growth in emerging markets is gradually improving on the back of higher commodity prices and economic normalisation in both Brazil and Russia (Figure 8). Significant progress has been made in reducing imbalances but political risk remains high in certain countries such as Brazil, Turkey, and South Africa.
Weaker growth for structural reasons, but no immediate recession
Weaker underlying growth is structural
Current global economic growth is indeed weaker than the 2003-2008 period, but remains in line with average growth over the previous thirty years (Figure 9). Developed economies are growing at a slower pace than previously, but unemployment is falling at least as fast. This situation can be explained by lower potential growth due to disappointing productivity levels in most developed economies, and by less favourable demographics.
No immediate recession
The global cycle should remain closely linked to that of the US, which is far from a recession. A mid-cycle decline in business investment, as seen recently, is not uncommon: a more typical precursor of recession is the reversal of household-related cyclical components (Figure 10). Currently, their improvement is ongoing and they are still a long way off previous cycle peaks. Two main scenarios seem plausible: a mild recession in the US economy in two or three years’ time, or a longer expansion but that is followed by a deeper recession. The Federal Reserve’s monetary policy will partly determine which scenario will prevail.
The Fed is expected to raise rates at least once this year
According to the Taylor rule, the Federal Reserve should already have upped its rates long ago (Figure 11). Indeed, the unemployment rate has declined faster than expected. Although low inflation significantly influenced the Fed’s decisions, it has also paid greater attention to market volatility. Various FOMC members’ speeches hint at rate rises, whilst others are more wait-and-see. However, the Fed will probably resume tightening in the near future. This tightening of the Fed’s monetary policy should strengthen the dollar, pushing EUR/USD closer to 1.05. The Fed’s rate hike is likely to drive long-term rates up, but the ECB’s corporate sector bond purchasing should support high yield credit in the Eurozone.
Earnings forecast upgrades should support eurozone equities
Lower underlying growth does not necessarily mean lower stock market performance. In the short term, stock market shifts are more closely linked to cyclical factors than to underlying growth. However, despite a favourable cycle in the Eurozone, corporate earnings forecasts for 2016 were revised sharply downwards at the beginning of the year due to falling commodity prices and lower interest rates which weighed on financial stocks. This tide is starting to turn, and an uptick in results is noticeable (Figure 12). Moreover, while bond yields remain low, equity yields have remained reasonable. Eurozone equities are trading at a historically high discount compared with the US (Figure 13).
What to watch in the months ahead
In the months ahead, investors will be keeping a close eye on major central bank meetings across the globe (Fed, ECB, BoJ) and on significant shifts in economic data. The Fed and the BoJ both have meetings scheduled for September 21st and the ECB’s next meeting will be held on October 21st. The OPEC summit in Algiers on September 27th is eagerly awaited because of a possible oil-production agreement between its members. Political risk relates primarily to the constitutional referendum in Italy, for which no exact date has been set, and to the US presidential election on November 8th.
Our view on the main asset classes
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