Here are two macro themes which we believe will influence markets in 2018.
Theme 1. Goldilocks gives way to reflation
As 2018 begins, the activity picture remains strong. Business is confident and leading indicators signal robust growth ahead (chart 1).
Chart 1: Global activity indicator remains robust
We upgraded our global growth forecasts in November, but activity since then has proved to be even stronger than expected. Retail sales in the US have been very firm following a buoyant Black Friday and Cyber Monday, no doubt helped by sales of the new iPhone X. The Atlanta Federal Reserve estimate that US GDP is on track for 2.8% growth in the final quarter of 2017.
Business confidence in Germany is close to all time highs according to the Ifo institute survey and Japanese surveys (both Tankan and Shoko Chukin) are strong. The picture is less robust in the emerging markets where China’s growth is moderate rather than booming, but overall the synchronised global recovery lives on. One of the key elements of the upswing is the revival in capital investment which is expected to continue judging from orders data in the US, Germany and Japan. The recently passed Tax Cuts and Jobs Act in the US will also boost capital spending through the increased depreciation allowance.
Alongside stronger capex we are likely to see firms continuing to add jobs. Since 2015, the US economy has enjoyed a period where the unemployment rate has not dropped as rapidly as might be expected from the growth in non-farm payrolls. Instead participation rates increased as people came back into the labour force. This supply side response has helped keep wages in check. More recently the unemployment rate has been falling more in line with payrolls and we do expect some modest upward pressure on wages as the labour market tightens in 2018 (see chart 2).
Chart 2: US payrolls and unemployment
More generally we see consumer price inflation rising in 2018. Pipeline pressures are rising and we expect firms to respond to the recovery in growth by raising prices more aggressively in 2018. We have highlighted the long lag between GDP growth and inflation many times over the past year as one of the best explanations for the weakness of core inflation in 2017. Going forward it is a key element in our reflation forecast (chart 3).
Chart 3: Recovery points to higher inflation in 2018
So the growth picture is good and perhaps President Trump’s forecasts for the US will be right. However, markets will face two challenges.
First, growth expectations are higher than a year ago. At that time the consensus for global GDP growth in the year ahead was 2.8%. Today the equivalent figure is 3.2% (see chart 4). Clearly the hurdle for markets to be positively surprised is higher.
Chart 4: Global growth expectations for 2018 have risen
Second, unlike in 2017, stronger growth is more likely to be accompanied by higher inflation and higher interest rates. As growth and inflation rise, the environment will become more reflationary and central banks will be keen to withdraw stimulus.
Interest rate increases are not necessarily bad for risk assets if they are accompanied by stronger growth, as in 2017. Further rate rises in the US will continue the process of normalising real rates and markets may well take them in their stride.
However, to the extent that rate rises are accompanied by greater concerns over inflation, investors will start to discount the end of the expansion. Consequently, a more inflationary environment will probably mean some compression on market multiples. Equity returns will be more dependent on a recovery in corporate earnings as a result. Such an environment would prompt a rotation toward more cyclical sectors and regions and a search for pockets of value.
Theme 2. The long farewell: the end of QE
Higher inflation expectations will also affect bond prices and yields, a move which could well be exacerbated by the end of the great quantitative easing (QE) experiment.
Policy rates in the eurozone are not expected to change in 2018, but here the focus will be on the European Central Bank’s (ECB) asset purchase programme which is set to halve from €60bn to €30bn per month from January. We expect it will end altogether in September.
Relative to the asset markets affected, the ECB’s programme has been more significant than that of the US Federal Reserve (Fed) as can be seen by the prevalence of negative five-year bond yields in core countries such as Germany and the Netherlands.
Meanwhile, the Fed has already started to reduce its balance sheet by allowing $10 billion of assets to expire per month in the fourth quarter. This will gradually step up until reaching $50 billion per month in the fourth quarter of next year.
These moves by the Fed and ECB mean that on our forecast the Bank of Japan (BoJ) will be the only central bank actively engaged in QE by the end of 2018. Intervention by the People’s Bank of China and Swiss National Bank in foreign exchange markets may continue, but the net result is that the overall level of liquidity is set to slow in 2018 and should begin to contract in 2019.
Chart 5: Global liquidity set to peak
Investors appear to be split on the implications of this move. Some see little impact while others are more worried. The market is inclined toward the former whereas we are in the latter camp. Our view is that it will become a significant theme with implications for bond prices as a major non-price sensitive purchaser (government) withdraws from the market. Whilst some see the BoJ as riding to the rescue with continued liquidity provision we would note that capital flows from Japan have eased off to the US since the hedging costs rose as the Fed raised short rates.
We would not expect bond yields to return to pre-QE levels given the changes in the world economy since the policy began. The slowdown in productivity and greater regulation of the banking system mean equilibrium real rates will be lower. Furthermore, central banks will also still have some control over the yield curve via short term policy rates and forward guidance. Private investors will have to weigh these factors to determine fair value in a post QE environment.
Overall, the likely outcome of saying farewell to QE is likely to be some modest downward pressure on bond prices. In our view, the biggest losers will be those who benefited the most, so we would watch areas such as the indebted periphery of the euro area for signs of stress.
In summary the return of inflation and the moving away from Quantitative Easing by governments will be major themes that will impact the value of assets and stock markets in 2018
Author: Keith Wade, Group Head Economist and Grace Canavan, Head of Intermediary Business Development, Ireland. Website www.Schroders.com and contact number +353 (0) 85 254 9839.
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