Economic Insights - September, 2017
- Global expansion stays on track: The global economic recovery that began in early 2016 has reached a self-sustaining velocity. Even the consensus accepts the evidence. Momentum is likely peaking now, but solid growth should persist well into 2018.
- Robust growth, less accommodation: The global expansion rolls on and many central banks are contemplating reducing monetary ease. With higher oil prices, solid global growth, and fading investor caution, long-term sovereign bond yields should work higher into year-end.
- Asset allocation - return to reflation: Cyclical securities rebounded in September because investors judged the global upturn to be self-sustaining. Robust economic conditions suggest there’s more rally ahead. However, rising interest rates or inflation concerns could trigger a correction from high valuations.
Global expansion stays on track
The global economic recovery that began in early 2016, after the U.S. dollar peaked and commodity prices troughed, has reached self-sustaining velocity. Even the consensus now recognizes the evidence: strong industrial production, robust growth, and improved capital spending. Plus business and consumer confidence is surging to high or record levels. Stock market internals confirm the reflation:
- Interest rates are low.
- Profits are rebounding.
- Caution is fading.
- Small-cap and value stocks performed better relative to large-cap growth stocks in recent weeks.
Bank indices had better returns than the overall market. Mildly rising interest rates also suggest that investors appreciate some of the more recent worries (i.e., risks of deflation, political turmoil in Europe, or a China hard landing) have fallen significantly.
The Eurozone economy is surging. Economic sentiment there is within a whisker of a 17-year high. Confidence improved in every sector and country. Even Italian CEOs have the most optimistic outlook in a decade. The final survey of manufacturing purchasing managers was 58.1, the highest in over six and a half years. The flash composite of service and manufacturing indices rose a point, to a robust 56.7. Private demand is driving growth in both consumer spending and investment. In September, inflation stayed modest at 1.12% over the prior year, above the 0.81% level of the fourth quarter. Unemployment is falling and job gains are healthy. The 5.6% jobless rate in Germany is the lowest it’s been since reunification in the early 1990s. Even Brexit fears can’t keep the UK economy from expanding, or household spending there from growing.
Third-quarter growth in Japan won’t equal the healthy 2.5% annualized pace of the second. But the data is strong enough for Prime Minister Abe to gamble on increasing his majority in the Diet by calling a snap election for October 22nd. The labor force participation rate is the highest in nearly fifteen years; it should be, since the jobless rate is a measly 2.8%, with 1.52 job offers for every job applicant, the highest since February 1974. Corporate profits keep rising to record highs and investment is picking up.
Purchasing manager indices from the National Bureau of Statistics suggest that both manufacturing and service businesses are improving in China. The former survey hit a five-year high at 52.4, and the service index jumped two points to 55.4. August industrial profits are up 24% from the prior year. The private-sector gauge from Caixin/Markit slipped a bit, but still shows growth. The People’s Bank of China revealed a targeted cut in required reserves for banks that increase lending to small and very small enterprises, so while fiscal stimulus has faded some, there will be plenty of liquidity. Growth is not accelerating, but no near-term hard landing is anywhere in sight. Still, with debt rising faster than nominal growth, there is real potential for a financial disturbance somewhere down the road.
A weather forecaster in Los Angeles has a standard outlook: warm today, warm tomorrow. That has described the U.S. economy very well the past year. Real economic growth averaged 2.2%, matching the rate over the entire expansion. Confidence is high, job growth is robust, and inflation is subdued. The story hasn’t changed, and it’s a good story.
Small-business optimism from the National Federation of Independent Business rose to 105.3 in August, near the twelve-year high of January. Other measures of overall confidence are mixed, perhaps reflecting hurricane-related stress, but stay at the highest levels since 2000. Job gains have been excellent in the face of a low unemployment rate. Payrolls rose an average of 185,000 per month the past three months, right at the twenty-four-month average of 191,000.
Regional manufacturing surveys from the Federal Reserve (Fed) were very strong in September. Profit growth is rebounding, and capital spending is clearly picking up. We expect third-quarter growth to be cut a few tenths by the tragedies that came with Hurricanes Harvey, Irma, and Maria. Rebuilding efforts could add a bit to growth in following quarters. With the economy firing on all cylinders, the next few months could look like the economic environment of late 2016. Our U.S. forecasts are in tables at the end of the commentary. The outlook for selected U.S. data is in the chart below.
At cycle peaks:
What happens when governments supply fiscal stimulus to already robust economies rather than during recessions or tough times? We may find out. The U.S. Congress will soon discuss a tax bill with large business tax cuts. Japanese officials suggest future tax hike proceeds be used to support education. The German election combined with French President Macron’s plans for a more integrated Europe may result in looser budget constraints. Cuts to required reserves in China are also a stimulus. If reflation doesn't ignite on its own, fiscal stimulus may do it, perhaps even bringing concerns of overheating.
Robust growth, less accommodation
As the synchronized global economic expansion continues robust and unabated, central banks are re-evaluating the extraordinary policies put in place after the financial crisis. The Federal Reserve was first out the gate with an initial hike in the fed funds rate in December 2015, followed by a second one last December, and two more so far in 2017. The fed funds rate is now in a range of 1.0% to 1.25%. The Fed also announced the first step in reducing its huge bond portfolio would be in October. Market expectations for a fifth Fed rate hike this December are well above 50%, which would push the rate to an average 1.28%. The Bank of Canada also began to remove its monetary ease with two 0.25% hikes to bring its policy rate to 1.25%.
So far, the European Central Bank (ECB) and the Bank of Japan (BOJ) seem content to let the Fed set the pace. The ECB Governing Council made no change in its current policy at the September meeting, and made no statement about any change in its bond-purchase program that is scheduled to stop this year-end. ECB President Draghi did indicate such notice would occur in the fourth quarter, which investors assume means October. Draghi reaffirmed that policy rates would remain unchanged until “well past the horizon of our net asset purchases,” and emphasized the “need for a very substantial degree of monetary accommodation to secure a sustained return of inflation.” The ECB’s job is complicated by stunted inflation and by a strong currency, which has risen 12% versus the dollar in 2017. The strong currency is a drag on import prices, though it helped keep the measure of core consumer prices (ex food and energy) at 1.1%, down a bit from 1.2% in August. Still, that is up from 0.8% at the end of 2016.
The economy in Japan is doing well, but inflation stays very weak and overall prices are up just 0.7% over the prior year in August. Core prices (ex fresh food and energy) are up only 0.2%, and wages haven’t kept pace with economic growth. So, the BOJ has little interest in changing its extremely accommodative policy.
Rates moved higher:
Robust world growth, higher oil prices, and rising investor confidence in the self-sustaining expansion, pushed government bond yields higher, reversing their July-August dip. Yields on ten-year U.S. Treasurys ended September at 2.32%, up 0.2% from the end of August, and flat for the third quarter. Yields on 10-year UK gilts jumped 0.34% during the month to 1.36%. 10-year German bund yields rose a bit to 0.46%, also about flat for the quarter. The BOJ keeps the 10-year government bond yield near zero, although markets pushed the yield to 0.05%. Recent U.S. rate history is in the chart below.
Interest Rate Outlook:
The key question is where long-term rates go from here. Yields have been historically low, in part from central bank purchases and ownership of large quantities of sovereign bonds. But, yields have also stayed low from the shadow of the severe financial crisis, and the flight to safety by investors.
On short rates:
In recent comments, Fed Chair Yellen, reiterated her belief in above-trend growth, stronger labor markets, stable inflation expectations, and upward pressure on inflation. Yellen seems dovish no more, and believes the recent weak inflation reports are unrelated to each other and will fade so long as growth remains solid. In her last speech, Yellen noted that the Fed shouldn't be too slow to remove monetary ease because job gains are above long-term potential, risking overheated wage gains and an inflation problem. These comments appear to support one more rate hike in December, although we think it’s only an even chance. If the Trump administration can pass tax reform by the end of the year, the December rate hike is probably a lock.
Lower for longer?
Some make a case that long-term developed-country government bond yields could stay far lower than historically for two structural reasons: falling potential growth and low inflation. Aging demographics in developed countries means the growth in the number of workers will be less than recent decades. U.S. labor force growth is currently about 1% annually, versus 3% in the 1970s. Even that 1% is well above the 0.5% to 0.75% current population growth. Slower growth in the number of people working implies weaker economic growth.
Inflation could also stay below the Fed’s target for some time. There’s the Amazon effect of extreme competition and price transparency keeping price rises slim, the rate of technological change is accelerating and pushing advances in efficiency, robotics and artificial intelligence may replace many jobs - keeping wage gains modest, and infrastructure spending in Africa and other less-developed areas could expand the global labor supply by hundreds of millions of new workers. All this suggests deflation could be more of a problem than inflation in the future. Slower growth and modest inflation are structural reasons interest rates may never return to normal past levels.
The global expansion is vigorous and self-sustaining, with energy lifting even in Europe. Of the 45 countries tracked by Organization of Economic Cooperation and Development, all are growing and many are accelerating. With the global financial crisis nearly a decade in the rear-view mirror, the dread, fear, and caution it generated is starting to fade. So, even if structural forces pressure long-term yields lower, cyclical forces of solid growth momentum should push rates higher in the near-term. Today’s 10-year U.S. Treasury yields of 2.3% are inconsistent with 4% or more nominal U.S. growth. So, while we await evidence about whether long-term yields will stay lower for longer, we expect long-term sovereign bond yields to work higher into year-end. Our forecasts for U.S. Treasury bond yields are in below.
Asset allocation - return to reflation
September was the month when the investment consensus began to revisit their flirtation with reflation that was so evident in 2016. Reflation, of course, is a pickup in cyclical economic activity, bringing a rebound in profits, a modest boost to inflation, and a mild rise in interest rates. Reflation’s counterpart in markets is a rotation in returns from growth to value, from large caps to small caps, and from defensive sectors to cyclical ones that benefit from improving activity. That’s exactly what occurred in September.
Broad equity indices performed relatively well, despite churning underneath the surface. Total return of the S&P 500 Index was 2.1% during September, and 4.5% for the quarter. The broad MSCI All Country World Index rose 1.8% for the month and 4.7% in the third quarter. Energy and industrial companies were among the best-performing sectors. Indices of bank stocks benefited from the rise in interest rates. Real estate investment trusts had a tough month and weak quarter because higher rates were a headwind. Many bond indices lost ground in September when reflation took hold. Even so, investors in the euro area and U.S. high yield bonds eked out decent returns.
A look ahead:
On average, Dow Industrials perform best in the fourth quarter. November has had the strongest average monthly return since 2010, followed by October. This year, October should be little different, because the U.S. and global economies are strong, year-over-year earnings growth is still accelerating (up nearly 20% for reported trailing twelve-month earnings to the second quarter), and interest rates are still low. We look for the reflation trade to continue through much of the quarter.
Stocks and bonds of emerging market companies typically perform well in periods of reflation. That was not true in September. The MSCI Emerging Market Index lost 0.6%, and emerging market bonds indices in local currency also had poor returns. We think that underperformance will persist. Emerging market stocks and bonds have been the best performers year-to-date. Even with a rough September. The U.S. dollar was weak, interest rates were falling, and commodity prices rebounded, all strong tailwinds for emerging market securities. Those advantages are over and have become headwinds. Europe and Japanese stocks will likely replace them as the leaders for a while; their major indices had a strong September.
While the stock market rally will likely continue a bit longer, the long term is what’s important, and that outlook is less exciting. Eight or more years of super-low interest rates and very active central banks, combined with decent growth, have driven stock and bond prices to high valuations. The most important determinant of good long-term returns is the initial price paid These high initial prices suggest long-term returns will be modest at best.
The interim potential for the stock market will be determined by reports of inflation and further increases in long-term interest rates if any. Another 5% or so of continued advance doesn’t seem unreasonable. The odds of a real bear market, a drop of around 25% or more, seem remote at this time. That type of decline is usually associated with a recession and current economic conditions don’t suggest one anytime soon. However, a sudden or continued rise in interest rates, and a revival of inflation concerns could easily bring a significant correction to this highly valued market. The global economy is likely at peak growth momentum now. Any deceleration into year-end or beyond coupled with higher long-term rates could precipitate a correction. So, the potential for a longer rally is still there, but interim risk is rising. Those of the faint of heart might want to use this rally to take a few more chips off the table.
For a full set of our charts, please download the pdf