Last year’s global reflationary recovery has been cooling off this year. While corporate earnings, stock prices, and economic sentiment surged to records, actual and expected inflation rates have slipped below targets. The current situation thus warrants an increased focus on downside risks. But it would be too early for a defensive overall assessment.
The macro backdrop has remained benign during the first half of the year. The developed markets (DM) reported sufficient real output gains, tightening labor markets, and robust rebounds in corporate earnings. Business and consumer surveys surged or hovered near multi-year highs, even as some data began to soften.
Equity indices rallied to new records in the US, and finally reclaimed pre-2008 crisis levels in several Asian countries. Europe and the emerging markets (EM) are still farthest away from pre-crisis levels - but made up for that by comfortably outperforming. EM debt and corporate credit markets also offered above-average returns.
The main difference to 2016 concerned the weakness of the commodity theme within the EM, as relative strength has shifted from commodity-linked economies (e.g. Russia, Brazil) to the investment-, manufacturing-, and service-oriented markets (e.g. South Korea, China, Taiwan, Hong Kong). Last but not least, the eastern EU member states also joined the global outperformers, reflecting the strong cyclical recovery in the eurozone as well as the rebounding political confidence in the EU.
Against this upbeat background, the US Federal Reserve (Fed) decided to raise its policy interest rate twice (in March and June), and most recently reaffirmed its intention to start gradually shrinking the monetary base as early as before the end of the year (i.e. “balance sheet normalization” or “quantitative tightening”). Herein lies a certain risk for the global outlook in the near-term.
On the plus side, the Fed’s tightening plans have not meaningfully hurt global growth expectations yet, as buoyant stock markets and earnings projections suggest. On the cautious side, particularly since the Fed’s March rate hike, both actual and expected inflation rates have been steadily falling below the targeted medium-term levels, and bond yield curves have flattened close to recession levels (see charts 1-4, page 2). Furthermore, the incoming macro data is generally not as strong as many of the elevated sentiment indicators would suggest. These developments show that the government bond markets are increasingly uncomfortable with the current monetary policy settings, and/or the divergence between lofty expectations and a more modest economic reality.
The resulting downside risk for markets may not be imminent, but needs to be kept in mind for the coming months, particularly if inflation fails to rebound, as the Fed and other central banks predict at present. Lower future inflation rates equal slower future gains in nominal gross domestic product, which in turn translates into reduced corporate earnings growth in the future. Hence, if the current disinflationary trend fails to reverse, it will probably become more difficult for companies to keep surpassing the steadily rising profit forecasts.
That being said, the broader macro view remains constructive: after all, the current bull market is underpinned by fundamentals, i.e. corporate earnings. In fact, earnings have risen faster than equity prices in most markets this year, which is why valuations are still mostly somewhat lower today than six months ago (see chart 5, page 2). Hence, from a fundamental viewpoint, markets retain a significant upside, if inflation stabilizes as predicted (or central banks adjust their stance in case it does not). At the same time, they also offer a valuation buffer to the downside, if data or policy disappointments were to persist for a while. The latter does not exclude temporary selloffs, of course, but it does make the bull market more resilient during interim phases of uncertainty.
Note: The next edition of the LGT Beacon is scheduled for 12 July 2017.