Three key takeaways
✔Global growth is accelerating and becoming more synchronized.
✔In the U.S., the consumer is strong, but pickups in wage pressures and inflation are pressuring corporate profits.
✔Relative to U.S. stocks, international stocks offer cheaper valuations and some emerging markets are in the more attractive earlier business cycle phases.
For now, the risks of trade protectionism are offset by global reacceleration. Read why.
Although trade policies represent a risk to the economic outlook, the global expansion continues to gain traction and provides fundamental support for the outlook for international equities. Around 75% of the world’s largest countries’ leading economic indicators are rising on a six-month basis, up from 40% one year ago. The lagged effects of China’s 2016 stimulus-induced reacceleration are showing up in global trade and industrial data, as well as the recovery in global commodity prices. Purchasing manager surveys show positive bullwhips (i.e., new orders less inventories) in around 80% of the world’s largest countries, almost all of which have risen during the past year (see chart). And low interest rates, accommodative global monetary policies, and the shift to easier fiscal stances remain generally supportive of growth. So, while global economic growth remains slow, cyclical traction keeps the odds of global recession low.
A closer look at business cycles around the world
The global economy’s cyclical acceleration has been driven by the collective economic influences of multiple countries. The following commentary provides some insight into the business cycles of the world’s major economies.
Consumers support continued expansion: Favorable employment conditions contributed to a significant amount of tightening in the labor markets. Hiring has remained solid, albeit at a slower pace than a year ago, and wage growth continues to accelerate. These trends are consistent with historical late-cycle dynamics. Consumer sentiment has improved post-election, particularly for consumers who don’t possess a college degree,1 but has yet to translate into an acceleration of consumer spending. Tight labor markets and rising income suggest that the U.S. consumer is providing a solid foundation for continued U.S. expansion.
Inflation is accelerating: As we have expected for several quarters, continued wage growth—along with higher oil prices—is generating a meaningful rise in inflation in early 2017. Prices paid by the manufacturing sector have surged to their highest level since 20112 and commodity prices paid by consumers are rising on an annual basis for the first time in more than two years.3 In response, the Treasury market’s long-term inflation expectations have drifted above 2%. With core inflation firm and oil prices poised to rise above early-2016 trough levels, headline inflation could approach 3% by the end of the first quarter of 2017.
Mixed outlook for business sector: The U.S. business sector is experiencing a mix of mid- and late-cycle dynamics. The manufacturing sector continues to reaccelerate in tandem with the global expansion. However, the upside potential for earnings growth is limited by rising corporate profit margin pressures from both accelerating wages and rising interest expense.4 Small business sentiment has surged on hopes of deregulation and other policy changes, which have the potential to spur a recovery in business investment if they come to fruition. The corporate sector is boosted by the global industrial recovery and optimism about policy changes, although a maturing business cycle is likely to cap the potential upside.
The Chinese economy continues to experience an early-cycle recovery on the back of an industrial recovery boosted by last year’s dramatic increase in government stimulus. Manufacturing Purchasing Managers' Indices (PMIs) have remained in expansion for six consecutive months, but further acceleration may be limited as policymakers have already reined in support for the housing market. The rise in short-term interbank rates and the renewed pressure on capital outflows reflect continued risks to China’s overleveraged corporate sector, but policymakers thus far have appeared willing and able to calm financial conditions when necessary. China remains in an early cycle phase, but typical early-cycle upside may be absent given continued industrial overcapacity and an overextended credit boom.
The euro area remains in a mature and somewhat sluggish mid-cycle expansion phase. As global trade reaccelerates along with Asian growth, both the German industrial and service sectors are the healthiest they have been during this cycle. The outlook for the greater euro area, however, remains mixed amid still-elevated unemployment in the Eurozone periphery and the potential for political risk to weigh on consumer sentiment. Several major 2017 elections in core countries and the uncertain outcome of the U.K. leaving the European Union may pose risks, but overall, Europe’s cyclical expansion remains steady.
Brazil is in the early-cycle recovery phase, though some leading indicators have stagnated amid heightened political uncertainty. Growth should be helped by falling inflation and easing monetary conditions.
India’s underlying mid-cycle trends remain positive despite the recent decision to discontinue widely utilized large-denominated bank notes as legal tender. The demonetization has had some negative effects on the industrial and consumer sectors, but positive cyclical tailwinds are still dominating.
Japan and South Korea
Both countries have experienced positive spillover effects from large-trading partner China, which has helped lower recession probabilities. The cyclical paths of these countries are heavily dependent on China’s growth trajectory.
Canada and Australia
Both countries remain in late-cycle phases with potentially peaking housing markets. The rise in commodity prices has helped reduce the probability of these countries entering recession.
Asset allocation implications
In the aftermath of the U.S. election, asset performance and the consensus view suggested that new U.S. policies would raise growth relative to the rest of the world, boost the U.S. dollar, and damage the prospects of emerging markets via trade protectionism. Our view is that while such scenarios are plausible, the rapid market response is priced in a much higher probability than warranted. In contrast, we believe the global economic upturn is becoming more synchronized, with some emerging markets in more attractive earlier phases of the business cycle than the United States. In addition, international equities have cheaper valuations than U.S. stocks, and the U.S. dollar is now fully or over-valued relative to many currencies on a fundamental basis.
On an asset allocation basis, we continue to favor global equities. However, smaller asset allocation tilts are warranted due to the advanced stage of the U.S. business cycle, the wide distribution of potential policy outcomes, and rising geopolitical risk. As the U.S. proceeds further toward the late-cycle phase, exposure to inflation-resistant assets may become even more valuable to provide portfolio diversification.
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A Purchasing Managers’ Index (PMI) is a survey of purchasing managers in a certain economic sector. A PMI over 50 represents expansion of the sector compared to the previous month, while a reading under 50 represents a contraction, and a reading of 50 indicates no change. The Institute for Supply Management® reports the U.S. manufacturing PMI®. Markit compiles non-U.S. PMIs.
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