Global Growth Should Continue to Match the Positive Consensus Outlook
As a quick review, global GDP estimates for CY17 have not changed much since our March meeting’s forecast of moderate growth. Meanwhile, equity markets have in aggregate matched our fairly bullish targets, but bond yields fell compared to our expectation of increases. Looking ahead, despite all the troubles on the world stage, the Global Investment Committee estimates that for the next four quarters, the G-3 and Chinese economies will continue to match the positive consensus outlook and that central banks will only be gradually less dovish, while equity markets will continue their upward path, although in moderate fashion. We continue to think that bond yields will rise, but very slowly. As the Fed will be cutting its balance sheet soon and the ECB starts to taper its purchases soon thereafter, there is, however, significant risk of higher volatility and bond yields rising more than consensus, especially when US economic indicators rebound from their mixed 1Q results.
There is great market uncertainty about Trump’s and the Republican Party’s legislative success, but we still believe that a good portion of his plans will eventuate in the 2H17 or soon thereafter. Essentially, Republican legislators are in control of the agenda now, and they are desperate to overcome their internal divisions so as to achieve some success before the next legislative elections eighteen months hence.
As for geopolitical issues, we believe, as have markets so far, that such will be handled without crisis due to the strong economic incentives of all major players, although the situations in North Korea and the Middle East are at very dangerous levels. Even the stability of the domestic US political system is under threat now that both sides have been fueled into a frenzy.
As for the major economies, US GDP, at a 2.3% Half on Half Seasonally Adjusted Annualized Rate (HoH SAAR) in the 2H17, should match consensus expectations, with a 2.1% rate in the 1H18, which, although not booming, is quite firm. Growth should come from increased personal consumption, fixed asset investment, government spending and inventories, while net trade will likely be negative.
Meanwhile, the Eurozone’s and Japan’s GDP will likely grow at 1.7% and 1.4%, respectively on a HoH SAAR basis in the 2H17 and 1.7% and 0.9%, respectively, in the 1H18, approximately equaling consensus. These results should re-assure risk markets and corporate profit estimates should continue to show strong growth for CY17 and CY18. Personal consumption and capex should lead economic growth forward in each region, with trade being slightly positive for Japan, while slightly negative for Europe. BREXIT concerns will be increasingly crystalized in the coming quarters, although the real effect should be delayed to well into 2018. Japan will also continue to benefit from the large fiscal stimulus enacted last year.
Lastly, China’s official GDP should be 6.4% HoH SAAR in both periods, which is similar to consensus forecasts. Here too, personal consumption will likely lead the way, while fiscal stimulus will continue to provide some (but fading) support, including to private capex.
Central Banks: Continued Shifts towards Normalization
In March, we were more moderately hawkish than consensus by expecting the Fed to hike twice more in CY17 and to start balance sheet reduction by year-end, and such is now the consensus. We expect the reduction to begin in September and also now forecast 25 bps hikes in the 4Q17 and 2Q18. The ECB and BOJ, however, have stayed more dovish than we thought. In our March meeting, we did not expect many major changes in CY17, but the ECB did not use side-methods to mildly decrease accommodation like we thought it would. It has, however, seemingly indicated to market experts to expect QE tapering of E5BB per month cumulatively starting in January, which would mean no QE purchases at CY18-end. Meanwhile, the BOJ has done nothing to reduce accommodation, although it is buying fewer bonds than expected due to tight market supply and instead is relying on its 10-year bond yield target. Both are more confident about their economies now, but the odds of any major monetary change from the current consensus is unlikely. We also expect the ECB to hint, after it begins its indicated taper, that it will raise interest rates in late 2018. The BOJ in the 2H17 should indicate a less accommodative plan for 2018, but such will be made conditional on improving macro-fundamental factors. As we expect the economy to remain firm, with an increasing CPI, the BOJ should hike its 10-year JGB target to 0.3% in the 2Q18. As for inflation, we expect the US Core CPI to be 1.7% YoY in December, and as we expect the Brent oil price to be $49 then, we expect the headline CPI to be 1.7% YoY, as well.
Rising USD and G-3 Bond Yields
Given our scenario, we expect G-3 bond yields to rise gradually through the 2H17 and 1H18. For US 10Y Treasuries, our target for December-end is 2.4%, while those for 10Y JGBs and German Bunds are 0.1% and 0.45%, respectively. These are not major changes from current levels, and we expect only moderate further increases through June 2018, as well, at 2.6%, 0.3% and 0.65%, respectively.
For Australia, we expect 2.65% in December and 2.85% six months after that. This implies (coupled with our forex targets) that including coupon income, the Citigroup WGBI (index of global bonds) should produce a -1.3% unannualized return from a base date of June 18th through September in USD terms, -2.4% through December and -4.1% through June 2018. Thus, we continue to maintain an underweight stance on global bonds for USD-based investors. The WGBI index in Yen terms should be -0.2% through September, +0.6% through December and +0.5% through June 2018. As for JGBs, we target the 10Y to have a -0.4% total unannualized return in Yen terms through September and December, with -2.4% through June 2018, so within bonds, we clearly prefer overseas bonds for Yen-based investors.
Our scenario in March called for a stronger USD, but the opposite has occurred so far, mostly due to lower confidence in US reflation, coupled with greater confidence in Europe’s and Japan’s future. From the 113 level at our March meeting, the Yen is now 111.5 compared to our June-end forecast of 114, while from the 1,07 base level, the EUR is 1.11 vs. our 1.06 forecast. Clearly, confidence in Europe has improved due to confirmation of the relatively strong macro data and improved political prospects related to recent elections.
Because Fed policy will tighten faster than BOJ policy and we expect some US legislative reflationary success to finally occur, we expect the Yen to weaken to 114:USD at end-December. As for the EUR, we expect it to be 1.09:USD then. We expect 116 and 1.08, respectively, four quarters from now and the AUD to be 0.75 for each period, respectively, vs. the USD, thanks to relatively stable commodity prices and higher local interest rates. As for commodities, they have been quite volatile and driven by non-market events, especially the compliance and durability of the OPEC-Russia agreement, but the result has not been as good as we anticipated, although we did not expect a significant increase, due to stronger US oil production and lower Chinese reflation. Looking ahead, commodity prices should be relatively flat despite continued global economic growth, with our Brent forecast at $49 in December and $50 in June 2018.
Still Overweight Global Equities
Our March meeting’s MSCI World Index target for June was slightly exceeded by June 16th, with some countries rising less than expected, but others more so. As mentioned, despite all the political wrangling, we still think a good portion of Trump’s agenda will be enacted in the 2H17 or soon thereafter, including moderately-sized corporate tax cuts and some additional infrastructure spending, although it will be important for markets whether this is financed with short term deficits or offset by spending cuts. This success is built into US equity prices, so they will likely decline if the results disappoint some investors, but in the end, the animal spirits that have been released should keep the profit outlook strong and equity prices from falling too much. Other major global equity markets (see text below) should also perform reasonably well, so aggregating our national forecasts from our base date of June 16th, we forecast that the MSCI World Total Return Index will increase 3.0% (unannualized) through September in USD terms (4.2% in Yen terms), 5.6% in December (8.8% in Yen terms) and 10.7% by June 2018 (16.0% in Yen terms). Clearly, this suggests a continued overweight stance on global equities for USD- based investors (and Yen-based investors, as well).
Aren’t US equities too expensive? The answer is “Yes” if Trump’s agenda is not passed, but we think significant portions will be enacted and that the global economic reflation cycle will be hard to stop. Interest rates will rise, in our view, pressuring valuations a bit, but not by very much and Fed policy will remain quite accommodative. US deregulation and accelerated share buybacks are further icing on the cake, and although there are moderate profit headwinds from a mildly stronger USD, CY17 and CY18 earnings should be quite strong. Currently, because the tax cuts are not legislated, analysts are not adjusting their EPS forecasts for such, but this is likely a major anomaly that makes the market much less expensive than it appears. Indeed, we estimate that the market is trading on about 16.9 times CY18 EPS (and even less if buybacks due to the repatriation “holiday” are greater than expected). In sum, these factors should send the SPX to 2499 (3.3% total unannualized return from our base date) at end-September and 2687 in June 2018 (12.5% total return), which is higher than its peers and, thus, justifies an overweight stance.
European equity prices should perform quite well in local terms, with Euro Stoxx rising to 398 and the FTSE to 7620 at end-September (420 and 7920 in June 2018). This translates to 2.6% and 7.9% unannualized MSCI Europe returns in USD terms for those periods. Fears of a banking crisis have greatly diminished (although the threat remains) and global growth should cause consensus profit estimates to rise. BREXIT rhetoric will likely become harsher, and, thus, we expect UK equities to underperform the rest of the region, but the market will likely ignore the threats of a major disruption of European trade. Valuations in Europe are a bit high, but because of the improving intermediate-term profit outlook, we think they can be sustained despite a less dovish ECB stance ahead. Meanwhile, like our last few quarterly meetings, we still don’t see any European election leading to significant problems. Thus, equity prices can come close to rising along with earnings. In sum, we are positive, but will have a slightly underweight stance on the region.
In our last reporting period, Japanese equities performed moderately well in both local currency terms and USD terms, in line with the MSCI World Index. We expect TOPIX at end-September to hit 1633, with 1717 by June 2018 for a total return of 1.7% and 4.6% in USD terms respectively (2.9% and 9.6% in Yen terms). These are, of course, relatively muted USD-termed gains, as our Japanese equity team is not as confident in market sentiment as before. As for the fundamental drivers, we expect continued corporate governance improvement (including profit orientation and improved returns to shareholders) to be a prime positive factor, but macro factors are likely to play a positive role too. Japan’s economy will likely grow well above its trend, driven by improved consumer and corporate sentiment, as well as likely improvements in net trade after the 2Q17, as the global economy, especially in China, continues to grow. Such, combined with a weaker Yen, should be a positive driver for corporate profits, while valuations are reasonable, so the outlook is positive, in our view; however, given that the other regions’ USD-termed equity returns are higher, we maintain our slight underweight stance.
As for the Developed Pacific-ex Japan region, we expect Hong Kong and Australian equities to perform well, and as we expect their currencies will be stable, this leads to a 3.5% unannualized return in USD terms through September and 12.8% by June 2018. This is greatly due to China’s continued economic rise, its capital outflows to HK, and especially for Australia, China’s continuing demand for commodities and services. Thus, we will maintain an overweight stance on the region.
Investment Strategy Concluding View
After a strong start to the year, there was no value-added to be had, except in a risk-adjusted sense, by asset allocation between global bonds and global equities in the prior quarterly reporting period to June 16th, as both returned slightly above 4% on an unannualized basis in USD terms.
Looking forward, there is no doubt that the Trump agenda carries many uncertainties and that geopolitical tail risks remain quite large, but the Global Investment Committee remains upbeat because the net impulses for global economic growth and corporate profits continue to improve. Similar to our last meeting, this justifies an overweight stance on global equities, particularly for the US and Pacific ex Japan. Meanwhile, global bond yields should rise slightly, so we maintain an underweight stance on global bonds, with a slight overweight stance on USD cash for USD-based clients. For Yen-based clients, however, cash looks less attractive than global bonds, but more attractive than JGBs.