Developed Markets Quarterly Outlook

World Economy: Peaking or Escaping?

As the ‘secular stagnation’ narrative has given way to the ‘reflation’ narrative as the dominant market theme this year, the question arises whether the fairly synchronised upswing that has taken place since mid-2016 represents a mere cyclical peak or whether the global economy has achieved ‘escape velocity’ and entered a self-sustaining path. The latter is highly pertinent for the appropriate stance of monetary policy and thus the outlook for risk assets.

The global economy has experienced an uptrend in both developed and emerging markets during the past three quarters. In particular, the credit stimulus engineered by Chinese policymakers helped support domestic growth and, with that, contributed meaningfully to global growth. During Q1, Chinese growth perked up to 6.9% yoy as a result, whereas US growth went through a soft patch with a mere 0.7% qoq saar gain. The Eurozone clocked a strong 1.8% yoy expansion. Still within a context of overall strong growth, the situation has since reversed once again, with China seen as decelerating on the back of the recent implementation of credit restrictions, while the US economy is expected to rebound to near 3% in Q2, with subdued inflation.

These developments have brought the extraordinarily accommodative monetary policies of the Fed and the ECB into increased focus. While the Fed has now hiked interest rates three times from the low and expects to implement another two hikes this year, attention has turned to the size of its balance sheet and the prospect for unwinding part of its $4.5 trn size. At the same time, the ECB continues to purchase assets, albeit at a diminishing pace. Its members too are eyeing higher interest rates and debating whether rates should emerge from negative territory before QE ends. If activity is not well enough entrenched, such policy moves could derail the recovery and with it the market rally.

Market participants fear that even in the best of cases, any balance sheet unwind could be detrimental to the market outlook. After all, a recent Fed study estimated that the effect of the entire QE program was to reduce 10-year bond yields by some 120 bps, among other effects. Could the bond market thus be at risk of a large rout? That remains unlikely. For one, the scale of the balance sheet reduction is not going to be as sharp as its build-up and the Fed is likely to end with a balance sheet permanently larger than before the crisis. Second, markets have long anticipated the eventual unwind of the QE program, unlike its start. What is more, the wind-down is sure to be much more gradual, as the balance sheet declines at the rate at which its securities mature, at most. Only the timing of the start of the process is uncertain at this stage. Third, with both interest rates and the size of its balance sheet, the Fed has two policy tools at its disposal. It can use its rate tool to counteract any adverse effect the balance sheet reduction may have. Monetary conditions will be determined by the combination of rates and balance sheet size. Finally, changes in the monetary stance will only be undertaken to the extent that the recovery permits them and the Fed will likely continue to remain deliberately “behind the curve”.

To be sure, there are risks and challenges to the global outlook. The recent turn south in commodity prices is one, in particular if it were to continue further. In China, higher funding rates and tighter regulations in the lending and housing sectors could yet mean that the government is overtightening and throttling growth. In the US, the increasing political realism that meets the plans and proposals of the Trump administration risks deterring domestic capital expenditure. Already, the divergence in trends between buoyant ‘soft’ (survey) and more modest ‘hard’ (actual production) data is being resolved in favour of the latter. At the same time, strong employment figures still contrast with modest GDP growth - worrisome given the still-low level of interest rates. And finally record high stock prices and high political uncertainty are difficult to reconcile with VIX volatility readings below 10%, the lowest since 1993 (which incidentally, preceded a sharp run in inflation, 325bps worth of Fed hikes and a bond market sell-off).

Market Strategy

There are no significant signs that the global economy risks entering a recession in the near term. The US stockmarket stalled during the past quarter and the USD lost 1.2% in trade-weighted terms. But the economy remains on a cyclical upswing, even if potential growth has been lowered. We retain a small overweight to the US and also upgrade the Eurozone to overweight, where political obstacles have largely been cleared for the moment and where the recovery is gathering pace. Our key underweights remain the UK - on a Brexit-induced slowdown - and Japan, where the recovery remains agonisingly slow.

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