The Outlook: March 2018 economic commentary

Commentary

Colin Warren, chief economist at AFH Wealth Management, weighs in on market moves and investment challenges

 

The market environment becomes more challenging, but don’t panic

For investors lulled into a sense of security by the low-volatility, ‘halcyon’ days of 2017, recent weeks have provided something of a wake-up call. The global economic backdrop has turned less ‘goldilocks-like,’ and political developments in the US and Europe have also become less supportive. Whereas 2017 provided the ideal macro backdrop of upside global growth surprises and below-consensus inflation outturns, 2018 has seen economic data start to disappoint expectations in some regions, and inflation readings in the US have picked up somewhat faster than markets were anticipating.

President Trump’s first year in office was characterised by market-friendly policies including deregulation and tax cuts. But moving into his second year, the focus has shifted to trade, where the president’s protectionist instincts do not sit comfortably with investors. Similarly, in Europe, Emmanuel Macron’s victory in the French presidential election in May encouraged hopes that the tide of populism was in retreat and reform was in prospect. However, the strong showing of anti-establishment parties in Italy’s recent election has provided a reminder that nativist tendencies remain strong.

In the UK, the easy fudges that facilitated December’s Brexit divorce deal are now having to be translated into difficult practical solutions, not least in the matter of the Irish border.

Against this backdrop, it’s perhaps not surprising that markets have become more volatile. Global equity markets experienced their biggest fall in nearly two years in early February, when a weather-related spike in US wages sparked fears over inflation. Sessions when markets move 1% or more in a day – a rarity in 2017 – have become more common this year.


Trade worries

President Trump’s decision to impose import tariffs of 25% on steel and 10% on aluminium has given markets something new to worry about. The question facing investors is whether the move is just a symbolic sop to Trump’s voter base which, in itself, will have a minimal macroeconomic impact (such imports account for around 0.2% of US GDP), or whether it’s a precursor to a damaging trade war that would have much more serious repercussions for the global economy and risk markets. Crucial in this regard will be developments in the NAFTA (North American Free Trade Agreement) renegotiation with Mexico and Canada, and whether ongoing investigations into China’s alleged violation of intellectual property rights result in the introduction of broad-based tariffs. The departure of the ‘globalist,’ free-marketeer Gary Cohn as Trump’s chief economic adviser is a worrying omen on this front. If he’s replaced by a ‘protectionist,’ concerns over the direction of policy will mount.

Uncertainty about trade comes at a time when global economic data has started to disappoint expectations. There has been some evidence that growth momentum, particularly in manufacturing, is peaking, and data has fallen short of consensus forecasts. Figures for February showed the global manufacturing PMI – a timely indicator of private sector activity – falling for a second consecutive month, as growth in the euro area eased to a 4-month low.

A month or two of underwhelming data is not yet enough to shake expectations of solid global growth for 2018: business and consumer confidence remain close to historic peaks and the full impact of US fiscal stimulus is yet to be felt. However, recent developments serve as a reminder that, with growth and profit expectations having been revised up in recent months, there is a high hurdle to beat.


Faster rate hikes?

Inflation in the euro area and Japan remains subdued, but increased inflation risks in the US and the UK have raised the prospect of a quickening in the pace of interest rate hikes from the US Federal Reserve (the Fed) and the Bank of England (BoE). In the US, subdued inflation – in part due to transitory factors, such as a mobile phone tariff price war – meant the Fed withdrew monetary stimulus at a historically slow pace in 2017, hiking rates just three times. However, with the labour market tightening, core inflation moving higher and the already buoyant economy receiving an extra boost from the Trump tax-cut package, the new Fed chairman, Jerome Powell, has hinted that the pace could shift up to four rate hikes in 2018.

Across the Atlantic, BoE governor Mark Carney signalled in February that UK interest rates would have to rise ‘somewhat sooner’ and at a ‘somewhat greater extent’ than the authorities had anticipated. Later that month, he was quoted as saying that there were likely to be “something more than three rate increases – spread out over the next few years.”

Nevertheless, even factoring in a faster pace of monetary tightening, real interest rates are likely to remain historically low. Four quarter-point increases in the US policy interest rate would take it to 2.25-2.5% - barely positive in real terms if core inflation picks up to 1.9% as the Fed expects this year. If the BoE were to tighten policy at the same tempo (which, admittedly, seems less likely), Bank Rate would rise to just 1.5%, i.e. well below the 2% inflation target.


Did I mention, don’t panic?

What does all this mean for investors? Firstly, the prospect of UK savers receiving an inflation-beating return on their deposit accounts is still a long way off. Secondly, 2018 is unlikely to see real interest rates in the US rise to restrictive levels that in the past have pushed the economy into recession and ushered in a bear market in equities. To be sure, a hawkish tilt at the Fed is likely to herald more volatility in markets, given that the prospect of faster monetary tightening is not wholly priced in.

Choppier markets will be unsettling, coming after last year’s exceptional tranquillity. However, at this stage of the cycle, global equities still have better potential to deliver above-inflation returns than bonds and cash. Portfolio managers need to be responsive to the changing macroeconomic backdrop and evolving political risks, but there is no need to panic.


This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.

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