Economic Outlook for August 2017
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Economic Outlook for August 2017

During July Asia saw a strong equity market performance (the MSCI Asia Pacific jumped by 3.7%), whilst the S&P 500 in the USA recorded a 1.9% increase. Europe, however, lagged behind (the Euro Stoxx 50 was virtually unchanged with +0.2%). The divergence between the US and European markets can, to some extent, be attributed to the current weakness of the US Dollar. This is, however, unlikely to derail the performance of equities in the long run: it is important to stress that the effect of currency turbulence on corporate earnings is not straightforward and that there are many pitfalls in attempting to project recent currency trends into the (near) future.

Whatever the merits of currency effects, the global economy continues to show positive momentum, which is driving corporate turnover and can be expected to effect earnings in turn. The evidence of second quarter profit reports so far indeed corroborates the notion that growth acceleration drives earnings surprises.

Global economy: Growth accelerates

The IMF published its July Update of its World Economic Outlook, which included a moderate downgrade of the US growth rate and an identical 20bp upgrade for the Euro area. Looking at recent trends in lead indicators (such as PMIs) a further upgrade of European forecasts cannot be ruled out confirming the convergence of economic growth in advanced economies, which has been a major feature of the world economy this year. Another encouraging trend is the on-going acceleration of world GDP growth (from 3.3% in 2016), which leaves only a handful of countries in recession. In contrast with the start of the year, the IMF no longer projects a slow-down in the Chinese growth rate (where second quarter GDP growth surprised at +6.9%) and the turn-around in other key BRIC economies - Brazil and Russia - adds to the overall picture of a synchronized global growth momentum.

Global GDP Growth

% Change

2017

2018

World

3.5

3.6

Advanced Economies

2.0

1.9

Developing Economies

4.6

4.8

USA

2.1

2.1

Euro Area

1.9

1.7

UK

1.7

1.5

Russia

1.4

1.4

China

6.7

6.4

India

7.2

7.7

Brazil

0.3

1.3

SOURCE: IMF World Economic Outlook Update, July 2017

Approaching the end of Quantitative Easing.

In its press release of July 26, the Federal Open Market Committee (FOMC) stated that it left its key interest rate unchanged but also communicated that it “...expects to begin implementing its balance sheet normalization program relatively soon, provided that the economy evolves broadly as anticipated.” FED observers interpreted this statement as an indication that the process of a gradual reduction in the portfolio of assets, purchased during the Quantitative Easing build-up, will commence in September. At the same time, commentators have been reducing the odds of another interest rate hike in September to almost zero, even suggesting that no further rate hikes this year is a possibility. Clearly, stubbornly low inflation is influencing FOMC’s inclination to raise interest rates and the FOMC’s monetary policy stance can therefore be best summarized as one of a determined balance sheet reduction but with official interest rates remaining “low for longer”.

Although the future path of monetary policy by the ECB is less clear than the FED’s , there is no doubt that further strengthening of the European economy will ultimately lead to a similar scenario of normalization. The ECB has so far not communicated any discussion regarding the fate of its Euro 2.3 trillion quantitative-easing program, which ends in December. ECB president Draghi has indicated, however, that a reduction of asset purchases would not signal a tightening of monetary policy and thereby echoes the FED attitude. ECB observers have penciled in October as the month that more details about the ECB’s intentions regarding tapering of asset purchases will become public.

Corporate profits & exchange rates

Every global company has to deal with exchange rates which, at times, can be highly volatile and take unexpected turns. The Euro/USDollar exchange rate, for instance, started trading at 1.16 at the time of the Euro launch in January 2000. Since then it reached a low of 0.84 by October 2000 that year and showed a meteoric rise to 1.59 by July 2008; at the start of August 2017 it is almost back were it began in 2000. The foreign exchange market is characterized by periods of heightened volatility, high volumes and countless participants; it is generally regarded as one of the most efficient financial markets: news has an immediate effect on rates and predicting a trend is mostly futile. Recent evidence confirms this notion: confounding currency forecasters immediately after the US presidential election the US Dollar, rather than moving towards “parity” with the Euro as many predicted, has depreciated significantly recently: since the beginning of December last year up to the first of August this year it has fallen by 11%. This move has started to get noticed in some company reports of companies in Europe who have an exposure to US$ denominated geographies. An exporter from Europe to the USA will obviously receive less in Euro terms and in the current corporate reporting season (covering the second quarter) sales statistics from European companies have sometimes been less robust than their US counterparts.

It is important to note, however, that most global companies are aware of the effects of currency volatility and tend to either hedge foreign sales directly, establish on-the-ground operations in important markets such as the USA and/or finance foreign operations in local currencies (thereby establishing “natural hedges”). In assessing currency effects on corporate earnings analysts distinguish between a “translation” effect (profit margins of a company are not affected by currency moves) and the “transaction” affect (profit margins are affected): the transaction effect occurs when a product is exported from one country to another which has a negative effect on its earnings when the export market’s currency is depreciating (and the currency exposure is not hedged). Currency effects are therefore not straightforward and during periods of currency turbulence uncertainty amongst investors regarding the profit impact can lead to share price volatility around earnings reporting seasons.

Unfortunately market-wide statistics do not provide sufficient detail to isolate currency effects on reported sales and earnings trends. Considering the current weakness of the US Dollar against the Euro, investors in European companies will be assessing the profit statements of companies with a US footprint with additional interest. Current earnings forecasts indicate, however, that the positive effect of a strengthening global economy is likely to out-weigh any (temporary) negative currency effects. Yardeni Research recently forecast that profit growth in the US will be slightly above 10% this year whilst European profit growth is even expected to reach nearly 12%. Economic growth acceleration tends to feed through to earnings surprises: according to FactSet, with over half of the companies in the S&P 500 having reported second quarter earnings, more than 70% reported sales above analysts’ estimates which is significantly above the 56% average over the last year (and 53% over the last 5 years).


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