After a summer marked by geopolitical tensions, investors entered the fourth quarter of 2017 with renewed optimism in global growth. Notably, investor sentiment has become more upbeat relative to the summer, as signs of upbeat macro fundamentals and corporate strength have been the dominant theme driving markets. Higher oil prices, a firmer U.S. dollar, a less dovish tone to central banks, a steepening yield curve, improving leading indicators and a focus on U.S. tax cuts have all caused a rotation into year-long laggards adding a firmer foundation to the market.
As we move to close out the year, the global economy is enjoying a synchronized cyclical upswing. Improving global growth, better economic surprises in developed economies, largely accommodative central banks and improving earnings momentum are all driving global risk assets higher.
Here, we outline five economic observations, and the leading investment themes investors should be paying attention to as we approach 2018.
Economic Outlook: Five Observations
Nothing But Net: Global Growth Is Accelerating
In the last few months it has been clear that the global economy is enjoying a sustainable economic expansion with a long-awaited cyclical recovery in investment, manufacturing, domestic demand and trade. For the first time in a decade, major developed and emerging economies are in sync, enjoying cyclical growth upswings, an occurrence which has been rare over the last 50 years. Expectations are for growth to accelerate in many economies over the next 12-18 months, with economic growth supporting risk assets and capital markets.
Just Right: Central Banks Are Supporting Markets Despite A Tightening Cycle
Central banks have responded to quickening economic activity by signaling the coming of policy normalization. In the United States, the Federal Reserve’s FOMC announced the long-anticipated beginning of unwinding of the Fed’s $4.5 trillion balance sheet. The current program is to run off $10 billion in securities in the first three months, with the amount rising to $50 billion per month over several quarters.
A similar dynamic is occurring in Europe. European Central Bank President Mario Draghi jolted the market in the summer when he noted that the strength of the European economy warranted a consideration of policy response and a further tapering of central bank asset purchases. While all indications are that policy normalization is at least three years behind that in the United States, it is a signal to the market that the long-awaited recovery from the double dip recession in Europe is finally at hand.
In A Better Place: Soft And Hard Data Are Converging
Earlier in the year, market participants worried about the discrepancy between the soft data which pointed to expectations of a stronger business environment and hard data which was not meeting elevated expectations. In recent months, that gap has tightened, with economic activity in developed markets exhibiting strength and beating forecasts. This harmonizing of the hard and the soft data gives confidence in the sustainability of the recovery.
Still Here?: Structural Issues Remain
Despite this, structural impediments remain headwinds to growth. Investors find themselves in a place not much different from the one they had hoped to leave behind—steady if sluggish growth, global low rates, halting inflation and low productivity. While U.S. GDP did indeed come in at a 3.1 percent rate for the second quarter, growth is expected to come in around 2.2 percent for the year, slightly higher than trend. In the longer term, without a fiscal boost, it will be challenging to push growth to 3 percent with the U.S. job market already at full employment, historically low levels of labor participation, and slow gains in productivity.
Don’t Touch That Button: Policy Risks Grow
Heightened geopolitical risks in Asia and Europe and the administration’s preference for unilateral action increase the likelihood for an unintended outcome detrimental to both global assets and geopolitical stability. North Korea’s testing of an ICBM and China’s unwillingness or inability to reign in the regime stand as major threats to global order and could affect growth in Asian economies. On the trade side, the U.S. pledge to move away from multilateral international trade regimes in favor of bilateral trade deals lies at the heart of the administration’s trade agenda. Even so, recent U.S. trade actions have been less punitive than feared, helping lead a rally in emerging markets and currencies since the beginning of the year.
On the monetary policy side there is a real, though low risk of a policy mistake. The lack of global inflation is the central conundrum for central banks given that all have the policy mandate of price stability. Therefore, if the causes of low inflation remain a “mystery” then we have a policy problem. On the one hand, low global and domestic inflation reads are keeping central bankers cautious in normalizing policy. Some members of the FOMC believe that the hesitation to raise rates could lead to a future inflation spike leaving the Fed with no choice but to act aggressively. Others believe that any rate increase in the current tepid inflation environment could choke nascent recoveries given the clear global down drift of wage growth and service and goods inflation.
Market Outlook: 2017’s Three Investment Themes Remain Intact
BNYM believes there are three main investable themes for investors.
The first theme is one of synchronized global reflation and strengthening fundamentals. Recent data have pointed to a synchronized strengthening of global economies which tends to support growth sensitive assets, particularly equities. Fundamentals remain strong and there are few signals of a looming recession. Beyond the United States, economic conditions in Europe and Asia have improved, are accelerating, and recent data releases suggest these improvements can be sustained throughout 2017 and 2018. Equities tend to do quite well in growth environments. BNYM believes that overseas markets, including Europe, emerging markets and Japan are poised for outperformance.
While the U.S. recovery is in its ninth year, other countries are in earlier stages of the economic cycle, particularly Europe, Japan and emerging markets. Investors looking to boost capital appreciation and leverage cyclical growth are advised to allocate a portion of their capital to faster growing markets, both equities and fixed income. As recovery in European and emerging economies boosts U.S. corporate earnings, investors should look to invest in U.S. and global sectors, which benefit from this trend.
The second theme for the economy remains the potential for rising interest rates. The synchronized global growth profile also points to an unanticipated new dynamic—possible convergence, if fitful and slow, in global central banking as the Fed, ECB and BOE have signaled intentions to normalize policy.
Fixed income remains very expensive as economies have enjoyed a sea of liquidity for the last few years. A tightening cycle threatens fixed income portfolios with duration risk, which is unlikely to be compensated given current price levels. Unaddressed, rising interest rates can jeopardize both the income seeking and capital preservation goals of investors.
We believe that investors should reallocate capital towards unconstrained multi-sector fixed income products and increase global fixed income market exposure. In addition, investors should look to increase holdings of floating rate corporate debt, private debt, and investment grade corporate credit, laddered bond structures, and other “hold-to-maturity” strategies.
Finally, the third investment theme remains policy uncertainty and the risk of greater market volatility. Policy and economic risks abound. The pace of rate increases and the risk of over-tightening or under-tightening, fiscal implementation and effectiveness, potential trade disruptions, and geopolitical flare-ups are all sources of tail risk.
The ambiguity inherent in policy choices could magnify downside risks to assets globally. U.S. markets are currently pricing in a greater than 50 percent chance of a tax overhaul, which puts downside risk to markets should the plan fail to make its way through Congress.
Alicia Levine is a portfolio investment strategist for BNY Mellon Investment Management.