The Global Economy, Markets and Risk
The global economy is on the move, with an improving economic growth outlook, low inflation (with a few exceptions), healthier banking systems, and generally robust corporate profits. Although there is discussion that bond markets have entered a bear stage, equity markets appear to have room to march upwards. This is reflected by the consistent hitting of new records on the Dow Jones Industrial Average and the NASDAQ, the surge in Emerging Market stocks and ongoing interest in high yield. The Volatility Index remains wrapped around a 9-11 range, indicating that investors generally see a positive landscape to allocate capital. Banks, technology, mining and oil stocks have done well and will probably continue along that track in the first half of 2018.
Why the comfort level for investors? For the first time in many years the stars have aligned in terms of a broadly-shared period of economic expansion. As the International Monetary Fund noted in its January global economic update, “The cyclical upswing underway since mid-2016 has continued to strengthen. Some 120 economies, accounting for three quarters of world GDP, have seen a pickup in growth in year-on-year terms in 2017, the broadest synchronized global growth upsurge since 2010.”
The IMF January report also noted that growth was higher than expected for a number of countries in the second half of 2017, including Germany, Japan, South Korea and the United States as well as Brazil, China and South Africa. Moreover, “World trade has grown strongly in recent months, supported by a pickup in investment, particularly among advanced economies, and increased manufacturing output in Asia in the run in to the launch of new smartphone models.” Rounding out the picture, the global consumer appears to have a higher degree of confidence.
A major boost to markets was and will continue to be the Trump administration’s tax reform. Although the longer term consequences could be problematic (in terms of overly optimistic growth assumptions and potential revenue shortfalls when the next recession hits), the short-term results are likely to stimulate further expansion. As cash from of a number of companies returns to the U.S. economy it is expected to trickle down by bonuses, wage increases, stock buy-backs and dividend raises. Considering that around 40% of Americans are exposed to stock markets (including their 401Ks and IRAs), the tax reform does help stimulate growth – at least in the next couple of years.
Related to the improving global growth picture is that many Americans are likely to rethink keeping their money in money market mutual funds. At the peak of the Great Recession the amount of money in retail money funds topped $3.8 trillion. As the stock market has continued to roll along that number has declined. According to the Federal Reserve, money market mutual funds (as of Q2 2017) were a little over $2.75 trillion. Although interest rates are set to rise, money market yields remain low and equity markets still are likely to offer a better rate of return.
Consequently, with a feel-good from tax reform, better rates of return than money market funds and a pressing need for yield, we suspect that some of the money may flow into equity markets sometime in the first half of 2018.
Another factor that points to further stock market gains is faith in central banks. Under its new chairman, Jerome Powell, there continues to be confidence in the ability of the Federal Reserve to guide the economy. At the European Central Bank Mario Draghi is also well respected and seen as a steady hand – even if his institution eventually shifts to a less accommodative policy stance. The same can be said about the Bank of Japan and its head, Haruhiko Kuroda, who thus far remains committed to an easy money policy and getting inflation to its 2.0% price stability target.
The bottom line with central banks is that they are on a path for a very gradual normalization of interest rates.
What can go wrong in 2018? The short answer is plenty. Inflation can rise at a quicker than expected pace, forcing the Federal Reserve and other major central banks to raises rates at a faster pace. Such a development would be a shock for markets, especially as many investors have been lulled into the comfort zone of well-signaled and transparent central bank actions. It is one thing to say that you are going to take away the liquidity punch bowl and do it in a slow fashion – and suddenly cutting everyone off. Alternatively, fear of precipitating a market downturn could cause central banks to maintain a slower pace of tightening than might be justified given improving fundamentals.
The geopolitical calendar is considerable. There are major elections in Italy, the United States, Brazil, Mexico, Russia, Malaysia, Colombia, Costa Rica, and Sweden. Political risk is higher than usual in the United States, considering the risk of another government shutdown, the debt ceiling and Russian influence probes. The Middle East remains a bubbling cauldron of geopolitical risks, ranging from Turkey’s growing aggressiveness vis-a -vis the Syrian Kurds (who are backed by the U.S.) to the Iran-Saudi cold war (with its arenas of Qatar, Yemen and Lebanon).
Probably one of the biggest concerns is the threat of a trade war between the United States and China as well as the Trump administration taking an ill-fated step in walking unilaterally out of NAFTA. The latter would certainly have an impact on equity markets, considering the wide range of U.S. companies that would be negatively affected by such an action. Currency fundamentals and adjustments are also a concern.
Top figures in the Trump administration have sought to clarify that U.S. trade policy is not moving towards “protectionism,” but to update a system that has become dysfunctional, especially for the United States. As Commerce Secretary Wilbur Ross stated at Davos, “These are old systems; the world has changed. Concessions made in the wake of World War II are not so appropriate as we get here to this year.”
For most other countries, however, the rhetoric out of Washington is much more sharp-edged and there is a very up-front disdain for multilateral agreements. Moreover, one of the first actions taken by President Trump was to pull the U.S. out of the Trans-Pacific Partnership (TPP), which has gone ahead without the U.S. Trump’s 2017 Asian trip was colored by the President’s preference for unilateral trade agreements over multi-lateral deals. While the TPP has gone ahead, there have been no takers for a new bilateral deal with Washington.
The risk facing the global economy and markets is that trade tensions cause a high level of friction between the U.S. and China, respectively the largest and second-largest economies in the world. In late January, the Trump administration slapped steep tariffs on imported solar panels and washing machines, seen by many as an action against state-supported Chinese companies.
In the weeks ahead the Trump administration faces deadlines for presidential action on national security investigations into imports of aluminum and steel and a wide ranging probe of China’s intellectual property regime. The Trump administration is also in the latest round of NAFTA talks, which have not gone well. Indeed, during the 2016 campaign Trump threatened to rip up the NAFTA agreement. This approach has many U.S. companies worried. The chairman and CEO of Cargill, David MacLennan, stated at Davos that while pacts brokered decades ago “need a facelift,” he was wary of pulling out of NAFTA and that pulling out of the TPP was “not good” for his business.
While rising trade issues are significant, it appears that most investors shrug off the risk of trade wars with the view that cooler heads will prevail. Others argue that the tougher U.S. stance is all part of how the Trump administration conducts negotiations. While there may be some merit to this, such an approach does increase the chances that the other side may take the same approach and not back down, leaving the outcome to be a trade war that no one really wants.
What to take from all of this? In the short term global growth will help lift most boats. That means in the first half of 2018 the stock market is more likely to rise further than fall. As growth fuels demand, commodities will continue to look good, which should help mining and energy companies as well as tech companies. The gradual rise in interest rates should also help the financial sector at least in theory. Emerging markets will make up another group of beneficiaries as investor money needs to find higher yielding assets. Along these lines, we like Brazil, India and Russia, though geopolitical risks are a factor in each of these, especially the first and last. 2018 appears to be another record-setting year in global stock markets; the first half may live up to that, but the second half could be more treacherous. Invest with that in mind.
This article was originally posted in KWR International Advisor.