Mr. X, BCA’ loyal client paid us his annual visit to discuss the economic and market outlook. He is suspicious of the optimism in the macro and market air, and grilled us on the disconnect between the post US election euphoria in global markets and his more sober view that many of the secular drags on global growth will remain with us, even if policy shifts into a more pro-growth gear on a cyclical basis.
The US election did not trigger the flip of a switch in global growth momentum. It was already improving. The window between the end of deflation and the rise of inflation is a fertile macro environment for risk assets. Global inflation is likely to remain subdued for another couple of years because the global economy still suffers from a fair amount of spare capacity. Even though the global output gap has indeed declined from its post crisis 2009 peak, it’s still as large as in the early 1990’s.
Mr. X was quick to remind us that in addition to high debt levels and the apex of globalization, many other structural macro forces have driven down the advanced economies’ growth potential. We agree with Mr. X that it is premature to declare the death of secular stagnation, but over the coming 12 months, stronger cyclical economic momentum will be the dominant driver of bond yields, which we see grinding higher as inflation expectations continue to recover. American consumers are brimming with confidence, and the business sector is celebrating the prospect of a reduced regulatory and corporate tax burden under Trump as the 2-year US profit recession has ended. A surge in capex spending intentions registered in the regional Federal Reserve bank surveys foretells a pickup in overall economic growth. The contrast between rising optimism and flat current revenue growth, particularly in the small business sector, underscores how high expectations are…
With all the focus on the US of late, Europe is getting less attention for its above trend growth momentum. The euro area’s composite PMI survey has a good track record of leading European growth, and is consistent with a 2% level. Moreover, in its November report, the European Commission actually suggested that a rise in member states’ budget deficits in 2017 might make sense, no doubt partly a response to the populist backlash sweeping the region. The ECB estimates that the euro area’s output gap is still a wide 4% of potential GDP; wage growth is still weak, and declining, relative to the US. Europe is on the mend, but has a long way to go, and is still lagging the US in terms of business cycle expansion.
In contrast to the euro area, Japan has almost absorbed all the slack in its economy. The Bank of Japan actually estimates that it has a positive labor input gap, meaning the economy has run out of surplus workers. A tight labor market and pause in fiscal consolidation will be reflationary, but unlike the Fed, the BOJ has committed to letting inflation significantly overshoot before removing any accommodation. This commitment will sustain the US’s real rate advantage over Japan, a welcome development for Japanese equities.
So even as the euro area and Japan are recovering, neither central bank will pursue policies that interrupt the virtuous cycle sustaining upward pressure on the US’s real interest rate advantage which has been a powerful driver of dollar strength since 2014. The recent recovery in inflation expectations in both the euro area and Japan has outpaced the rise in their nominal yields, depressing real yields. We concede that bullish sentiment towards the dollar is stretched, but still think it can rally another 5% in broad trade weighted terms over the coming 12-18 months.
The virtuous feedback loop between dollar strength and lower real rates applies less to China and the rest of the developing world, even though they too are experiencing currency weakness. The end of wholesale deflation belies anxiety about the durability of the recovery in China’s ‘old’ highly levered and asset-heavy economy. The government engaged in hefty fiscal stimulus, increasing government spending significantly throughout 2015 and early 2016, but the growth tailwind from that fiscal thrust is now fading. The decline in real rates and return on invested capital in China has stoked capital flight, the politically destabilizing optics of which have prompted policymakers to impose a variety of restrictions to stem outflows. Meanwhile, because the RMB has weakened faster than factory prices have recovered, Chinese export prices are still deflating in dollar terms, which doesn’t bode well for pricing power throughout the rest of the global manufacturing and industrial materials complex.
While the reflationary window for global growth makes us bullish on global equities over a 12 month horizon, the US market appears to have discounted this goldilocks scenario. Bullish sentiment is stretched, earnings growth expectations at 12% y/y seem high in an environment where a tight labor market is driving up wage costs and a strong dollar will challenge industrial pricing power. Optimism about the economic benefits of the new administration’s policies could last while plans for tax cuts, increased infrastructure spending, and regulatory relief are being debated, but policy uncertainty is still sky high. U.S. profit growth may well come in just positive enough to sustain momentum, but we continue to have more faith in the constellation of monetary policy support, margin expansion potential, and lower valuation hurdles available in the Euro area and Japan.
Emerging markets are a tougher call. The combination of a strengthening US dollar, growing protectionist sentiment in the developed world, high debt levels, and weak productivity, are all bad news for emerging markets, which have lagged the post-election surge in global and cyclical relative to domestic and defensive sectors. This underscores that EM valuations are not cheap on an equal sector weighted p/e basis; non-financial return on equity is at a 10 year low; and net forward earnings revisions are still negative. Developed markets should outperform this year, even given the reflationary window that typically flatters EM equities. The burst of speed in deep cyclicals in the post-election period is likely to fade as the reality of a surging US dollar saps margin prospects. The more consumer-oriented, domestic plays will then shine. We are even more comfortable with that theme since the post-election relative valuation reset.
Amid this reflationary window over a cyclical horizon, in the very near term, investors should heed the rising risk of a correction, spurred either by the recent rise in bond yields or the unprecedented divergence between global policy uncertainty and market momentum.