Paul O’Connor, Head of Multi-Asset, discusses why investors have retreated from reflation trades since the start of 2017. He explains that, beneath the noise of policy and political news flow, the global economic recovery remains fairly resilient.
One notable feature of financial markets over the past few years has been the contrast between the volatility of investor sentiment about the global economy and the stability of underlying fundamentals. In the first quarter of 2016 investors panicked about global growth, regained faith into the summer and then finished the year in a state of near-euphoria about global reflation. The early months of 2017 have seen yet another change of direction, with investors retreating from reflation trades1 in most asset classes, questioning whether their optimism for the recovery has run too far. This recent rethink has been largely US-centric, based on a reappraisal of the Trump administration’s expected economic stimulus and an impatience that hard economic data2 in the US have not yet delivered on the promise shown in softer survey data (chart 1).
Chart 1: US consumer confidence and growth in personal consumption
Source: Bloomberg, US Consumer Confidence Index monthly data and US Personal Consumption quarterly data (percentage change year-on-year), from 31 December 2003 to 31 March 2017.
Despite these gyrations in market sentiment, the global recovery remains fairly resilient. Consensus forecasts3 suggest that real global gross domestic product (GDP)4 growth in 2017 will settle in the 3% to 3.5% range for the sixth consecutive year. If anything, this understates the health of the recovery in recent months. For one thing, growth forecasts for the major economies have been creeping higher since the third quarter of 2016, ending a multi-year era of persistent downgrades. In addition, the recovery is broadening, with all 20 of the world’s largest economies expected to grow this year – the first time this has happened since 2010. On top of this, the rebound in inflation in the developed economies to around 2% this year will give an extra boost to nominal growth. Encouragingly, these macro developments are now feeding through to corporate profitability. After more than five years in which global corporate earnings have barely grown at all, consensus forecasts are now for growth of 13% this year – which would be the strongest annual growth rate since 2010 (chart 2).
Chart 2: MSCI World corporate earnings index
Source: Bloomberg, MSCI World Index 12 month forward earnings per share (fwd EPS) and analysts’ consensus forecasts data as at 31 March 2017.
The great monetary easing is over
Naturally enough, as the rehabilitation of the global recovery continues, questions are now being asked about the extent to which monetary policy should now be shifting away from current, crisis-like settings. Of course, this journey has already begun: the US Federal Reserve has started raising interest rates, the Bank of England has probably finished its easing5 cycle and the European Central Bank is expected to begin formally tapering its quantitative easing programme early next year. Still, even though we expect central banks to move slowly, the important point here is that the great monetary easing is coming to an end. The key implication for markets is that many of the policy-driven trends that drove returns in recent years, such as the decline in bond yields, the rise in equity valuations, and the compression of credit spreads6, are now close to exhaustion. This doesn’t mean that investors can’t make money in 2017, but it does suggest that returns will be lower and more varied than in recent years. Asset allocation and active management look set to become vitally important.
Investors must now adapt to this regime shift, away from the post-crisis era of weak growth and extraordinary monetary conditions, towards something more normal. At the same time, they also have another regime shift to deal with, from a world in which politics had little impact on financial markets, to one in which it is now a major factor. The ‘known unknowns’ today are: the economic and geopolitical impact of the Trump administration; European elections; ‘Brexit’; and the fragile condition of the Middle East and North Korea.
Still, while we seem to have moved into an environment in which previously unimaginable geopolitical outcomes are now conceivable, it is not inevitable that the worst case scenarios will materialise nor that politics will overwhelm economic fundamentals. In our view, global macro momentum is still the key force driving the trends in financial markets – policy and politics are the noise. This was a key lesson of 2016, a year when markets rode through significant political turbulence, underpinned by the fact that the global recovery was strong enough to withstand the shocks, surprises, and uncertainty.
1Trading that reflects a belief in a reflationary backdrop, where prices rise alongside growth and inflation.
2Hard data = quantifiable measures of the economy (eg, consumption figures, unemployment numbers, average wages). By contrast, soft data refers to surveys based on sentiment or opinion (eg, consumer sentiment, business confidence).
3Consensus forecasts = predictions created by combining together a number of separate forecasts, typically from investment analysts.
4Gross domestic product, GDP = the value of all finished goods and services produced by a country, or group of countries, within a specific time period (usually quarterly or annually). It is usually expressed as a percentage comparison to a previous time period, and is a broad measure of overall economic activity.
5Monetary easing = action by a central bank to boost money supply and stimulate economic activity, such as lowering interest rates. When interest rates are at or close to zero, the central bank may undertake quantitative easing, which involves purchasing financial assets – often government bonds – on the open market.
6Credit spread = the difference in the yield of corporate bonds over equivalent government bonds.