Bob Baur
Global economic engine is chugging along
“The synchronised global economic expansion now underway is the latest in a series of transitions the world economy has recently experienced. In 2015, the world was near recession from the surge in the U.S. dollar and the collapse in oil prices that began mid-2014. Last year, a recovery began after the U.S. dollar peaked and commodity prices bottomed. Consumer and producer prices shifted from slowing inflation to accelerating price gains across a broad range of countries. This was clearest in China, where producer prices stopped falling in late 2016, for the first time since March 2012.
“In 2017, another transition emerged as recovery turned into a sustainable expansion that is broadly global. Inflation is gaining no ground, interest rates remain low, earnings and profits are climbing briskly, and confidence has decisively resurfaced all around. And while there are tentative signs of waning momentum, that doesn’t mean a slowdown, just a natural flattening in the curve.”
Central banks: slow, gradual and nervous
“While the synchronised upturn suggests that central banks should all be starting to normalise policy, that’s hardly the case. The Fed may defer its next rate hike until 2018, even though it is almost certain to implement its plan to reduce the size of its bond portfolio before year-end.
“The European Central Bank (ECB) met on September 7, but announced no policy changes. It did raise its growth forecasts and reduce its inflation estimates a bit for 2017 and 2018, and characterise Eurozone risks as ‘broadly balanced.’ Draghi reaffirmed that policy rates are expected to remain unchanged until “well past the horizon of our net asset purchases.” He emphasised ‘the need for a continued very substantial degree of monetary accommodation to secure a sustained return of inflation’ toward the ECB goal.
“The Reserve Bank of Australia will likely keep its policy rate at 1.5%, as it has for 13 months, even though Australian real GDP surged ahead 3.3% annual rate in the second quarter. That was less than expected. This robust growth, an excellent pace of full-time hiring and a good investment outlook, suggest that Australia has moved beyond the mining slump. But, the central bank is worried about the impact of high household debt, poor consumer sentiment, and stagnant wage growth on future consumption. The Bank of Japan stays with its super-aggressive monetary policy even though growth is strong and unemployment is ultra-low.”
Interest rate outlook
The consensus view seems to be that inflation is dead and interest rates will stay low forever. That belief has been validated by several sources:
- ultra-cautious central bankers
- recently weak inflation
- slump in the U.S. dollar
- chaos in the White House
- and geopolitical tensions which spurred a flight to safe havens.
“Further, if large central bank bond portfolios did truly push interest rates lower, then a reduction in the size of the Fed’s balance sheet should have the opposite effect and push yields higher. Last, few investors expect any part of the Trump fiscal agenda to be passed into law. After passage of the debt ceiling and hurricane Harvey relief funds, some sort of tax reform action seems more likely. Our forecasts for year-end yields for U.S. Treasury bonds are shown in the chart below. We expect the next Fed rate hike to occur in March 2018.
Asset allocation: low rates point to equity
“The key move for financial markets in August was the drop in long-term bond yields. U.S., German, and U.K. ten-year yields each fell around 0.2%. That, coupled with robust growth, produced nice gains in most types of global bonds for the month and for the quarter. The Barclays index of long maturity U.S. Treasury bonds returned 3.4% in August. Global high yield and emerging market bond indices had good positive returns.
“Geopolitical worries and falling expectations for enactment of any Trump-driven fiscal stimulus kept August returns for broad U.S. equity indices near zero. S&P 500 Index total return was only 0.3% for the month, and a price return of 0.1%. The Dow Jones Industrial Average return was only marginally better. Euro-area and Japanese indices actually lost ground during August. Emerging market stocks obtained the best returns, which benefitted from the weaker U.S. dollar, low interest rates, firming commodity prices, and vigorous global growth. The MSCI Emerging Market Index rose 2.0% in August, and increased 7.6% for the two months from July.”
By Principal Global Investors’ Chief Global Economist, Bob Baur, Ph.D.