‘Goldilocks’ economic conditions continue to sustain risky assets
US and eurozone PMIs underscore growth prospects; UK odd one out
Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.
- UK FORECASTS SIGNAL WINTER IS COMING
- CURVE FLATTENING: A SIGN OF FALLING INFLATION EXPECTATIONS
- ECB POLICY: TAKING NORMALISATION A STEP FURTHER?
Equity markets had a good week, with European and emerging markets outpacing the US despite the continued strength of the US information technology sector.
Recent economic data has reinforced the notion that economic conditions are in a ‘Goldilocks’ state, where relatively strong economic growth is not generating the sort of inflationary pressures that could prompt central banks to accelerate their normalisation of monetary policy.
Eurozone markets in particular benefited from strong economic momentum, with good economic news and sentiment indicators particularly buoyant. Forward-looking purchasing managers indices (PMI) for Europe were surprisingly strong, primarily in France and Germany, though it must be noted that these are survey data and we will still need to see the strength being translated into actual economic activity.
UK FORECASTS SIGNAL WINTER IS COMING
Bond yields were relatively flat over the week, although UK gilt yields came under pressure after the latest budget included chilling forecasts: the Office for Budget Responsibility downgraded its nominal GDP growth forecasts for the UK to below 1.5% per annum over the next three years. If this forecast is accurate, it will mean an extension of the long period of weak growth in average pay and income that has plagued the economy in recent years. It would require the UK to choose between further cuts to public services and higher taxes. We feel this news confirms our view that this month’s rate rise was a mistake. It may have to be reversed in 2018.
CURVE FLATTENING: A SIGN OF FALLING INFLATION EXPECTATIONS
Markets are not reckoning with any drastic shift in central bank policy. Instead, investors appear to continue to assume that any policy changes will continue to be gradual, though the stance in the US might turn more hawkish when stimulus measures including tax cuts move closer to final agreement and implementation. At this point, policymaker expectations of US interest-rate rises have not been discounted in market probabilities. While decision makers at the US Federal Reserve have pencilled in three more rate rises from next year (the first one next March), market forecasts of the fed funds target rate foresee only one move in addition to a widely expected increase by the Fed next month.
Pressure on long-term yields as inflation expectations fall has contributed to curve flattening. This affects the US curve more than the eurozone curve since on the one hand, the Fed has already embarked on interest-rate rises, while the ECB has taken only gradual steps towards scaling back its quantitative easing, while on the other hand, more US rate rises are seen as being in the pipeline, but ECB rate action is a more distant prospect.
As for the near-term policy outlook, the latest FOMC minutes showed that many committee members remained concerned about the persistent weakness in US inflation. After December’s rate rise, we believe further action will require clear evidence of inflation, even in the face of a tight labour market.
ECB POLICY: TAKING NORMALISATION A STEP FURTHER?
As for ECB policy, the latest policy meeting minutes highlighted the need to stress to the markets that quantitative easing would not end soon and that the governing council remained committed to the 2% inflation target. Comments by executive board member Benoît Cœuré also provided a useful insight into the current thinking of the council. He indicated the next likely change in the ECB’s monetary policy guidance would be the removal of the link between the inflation outlook and asset purchases at some point between now and September 2018. Such a step would signal the end of QE and mark further progress towards a policy normalisation under which interest-rate moves return to the heart of ECB strategy. The improving growth momentum in the eurozone could help convince other council members that policy normalisation can now be taken forward.
Eurozone inflation might show a bounce in November as the impact of the erratic factors that held back inflation in October reverses, which would put pressure on ECB President Draghi to strike a more hawkish tone at the press conference after the December policy meeting. In terms of the inflation outlook, this week’s meeting of OPEC members and other key oil producers on the existing package of production constraints should provide clues on whether oil prices will continue riding high. An extension of the current curbs to the end of 2018 is widely expected.
Written: 27 November 2017
Central banks induce regime shifts
So far so good, but markets underestimate risks
SUMMARY: US equities continued to outperform other markets such as EMU and EM equities. This partly reflects the divergence between the US economy -which is supported by fiscal expansion and a patient Federal Reserve- and relatively weaker growth in the eurozone and EM. But there is more to this divergence than faster US economic growth. The US equity rally has been led by the IT sector. This has accounted for 20%-50% of US equity returns since 2016. The rally is now looking stretched on various metrics. The other salient development in August was renewed stress in emerging markets (EM). A combination of economic stress in Turkey, weaker growth in China, Sino-US trade tensions and a stronger US dollar hurt EM assets. We believe there is value in EM assets, but the obvious circuit-breakers are still absent: a weaker USD, aggressive China stimulus and fresh Sino-US trade talks. EM assets prospects have soured and protectionism and tighter liquidity continue to cloud their longer-term prospects.