Economic Outlook for July 2017
During the second quarter the MSCI World Index rose by more than 3% in US$ terms but dropped by 3% in Euro terms. Towards the end of quarter global equities seemed to have a reached a crossroads as bond investors woke up to the realization that the normalization of monetary policies would be logical over the next 12 months. This resulted in a sell-off in bond markets, which also infected global equities, raising the question: to what extent should equity investors be worried about rising interest rates? It is important to keep in mind that central banks have been erring on the side of caution in their policy actions ever since the financial crisis. In light of low (and declining) inflation globally, it is becoming more likely that the normalization of monetary policies will progress at a more cautious pace. Under such policies equities would benefit from a scenario where interest rates stay “low for longer” and the economic momentum continues to drive corporate earnings.
Accelerating growth & subdued inflation.
Over the course of June incoming data supported the positive momentum of the global economy. In addition, updated forecasts from major institutions are being upgraded, supporting the view that the positive trend will continue during the remainder of the year and into 2018. The annual report of the Bank of International Settlements (BIS), for instance, does not mince words: “What a difference a year can make in the global economy, in terms of both facts and, above all, sentiment. The facts paint a brighter picture. There are clear signs that growth has gathered momentum. Economic slack in the major economies has diminished further; indeed, in some of them unemployment rates have fallen back to levels consistent with full employment...But sentiment has swung even more than facts. Gloom has given way to confidence.”
Increasingly, the confidence in a sustainable positive trend in Europe is rising, as reflected in the latest GDP forecast upgrade for the Euro area by the ECB (which now expects 1.9% growth for this year). In addition, the majority of lead indicators continue to paint a positive picture in the near term. One of the oldest lead indicators, the German IFO Business Climate Index, rose further (to 115.1) in June from its previous record in May (114.6). The IFO Institute, not known for the use of hyperboles, stated that ”sentiment among German businesses is jubilant” and that “Germany’s economy is performing very strongly.”
A widely accepted economic theory is that, when an economic recovery gathers pace, the labour market reaches full employment, which will then start to exert upward pressure on wages. The scarcity of labour would, in turn, drive inflation higher. This theory is known as the Phillips Curve and has remained a standard notion with economists inside and outside central banks in spite of the fact that it was discredited in the 1970s, when inflation increased dramatically in spite of high unemployment (a phenomenon that became known as “stagflation”). More than 40 years after the stagflation era the robustness of the Phillips Curve is again under scrutiny as labour markets in the US and elsewhere seem to be heading towards full employment and, yet, inflation remains low, and even seems to have taken another turn downwards recently. The ECB, for instance, reduced its inflation forecast for the Euro area from 1.7% to 1.5% for this year and the US saw core inflation of 1.7% in May (down from 2.3% in January). The recent apparent contradiction of declining unemployment and disinflation is driving a debate subject amongst economists with explanations being sought in temporary causes (an unexpected drop in the oil price for instance) and the deflationary effect of applying new technologies in everyday life (Ecommerce).
A dilemma for central banks
Most central banks aim (either explicitly or implicitly) for 2% inflation. Recent statements form both the FED and the ECB show that this target is being upheld in spite of recent low inflation readings. FED chair Yellen mentioned the “huge decline in cellphone service prices” as a factor underlying the declining US inflation trend whilst ECB president Mario Draghi mentions “a combination of external price shocks, more slack in the labour market, and a changing relationship between slack and inflation” in a speech on June 27. He goes on to conclude that “these effects, however, are on the whole temporary and should not cause inflation to deviate from its trend over the medium term.”
So, central banks are, for the moment, sticking with their inflation targets, but an increasing number of economists and policy makers are involved in a polemic re-examining of the “2% target dogma” and, related to that, the validity of the interest normalization process that the FED has embarked on (and the ECB is expected to commence if current growth trends persevere). A prominent member of the rate-setting Federal Reserve Open Market Committee (FOMC), James Bullard, told CNBC on June 30 that the FOMC should take a more reactionary approach to the normalization process, which represents a U-turn from his previous stance of the urgent need for interest rate rises.
At the start of the third quarter, investors can be forgiven for being slightly uncomfortable with a less-than-clear path for monetary policy (and interest rates) in the short term. What if inflation remains low for a prolonged period? The most likely scenario, under those circumstances, would be a more gradual normalization process with interest rates remaining lower for longer than central banks are currently planning. It is instructive to observe that, according to the CME FedWatch tool, the probability of a US rate hike in September has fallen to below 20% from more than 90% at the beginning of June. This scenario, although still somewhat speculative, would be positive for equities and growth stocks (which are more sensitive to the level of discount rates) in particular.
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