In our previous post we posed five questions for the US economy – with the Federal Reserve committed to rate hikes and a new tax bill that significantly restructures the US tax code, especially on the corporate side, there certainly is a lot going on within the US.
At the same time, economies around the world, particularly in developed markets, are seeing a simultaneous upswing. This was reflected across global equity markets in 2017 – the MSCI EAFE index (net, USD) gained 25.6% while the MSCI Emerging Markets index (net, USD) climbed 37.8%, both beating the S&P 500’s 21.8% return. As in the US, returns were powered by the Technology sector amid rising global demand. Even the manufacturing sector in developed markets appear to be booming. The obvious question then is whether this will continue, and that is where we begin.
Will global growth continue to steam ahead?
The global economy, especially in developed countries, has been on a remarkable upswing over the past year. Markit’s global manufacturing PMI ended 2017 at a near seven-year high of 54.5. Global manufacturing strengthened across several sub-indicators, including output growth, new orders and employment, providing an upbeat outlook for 2018.
Eurozone manufacturing PMI ended 2017 at 60.6, which is close to the highest reading ever. PMI levels are at or close to record levels Germany, Netherlands, Austria and Ireland, while France is at a 17-year high. Expansion has been led by investment goods amid a surge of business optimism in Europe, and this suggests that 2018 could continue where 2017 left off. Japan has also seen output growth pick up momentum despite ongoing structural factors like an aging population. The country is on track to see eight straight quarters of expansion as of the fourth quarter of 2017, which is its longest streak in 16 years. This has come on the back of rising exports and business spending, which should only continue if the global economy continues its recent trend.
Increased economic activity across the developed world also boosted emerging market (EM) economies. Inflation has been under control – commodity prices have been less volatile, remaining in a favorable trend for both importers and exporters. Credit growth has been strong in Asia, especially in China and South-East Asian countries like Philippines and Vietnam – though India pulled back due to demonetization and new tax reforms. Export-oriented countries vital to the global supply chain, like South Korea and Taiwan, also benefit from rising global demand. A potential headwind could arise if inflation picks up faster than expected in developed markets, without a proportionate rise in demand. This would force their central banks to tighten policy at a quicker pace and force EM policymakers to do the same even if it may not be ideal.
Will European and Japanese Central banks start to pull back ultra-easy monetary policy?
With Europe and Japan seeing robust economic growth for the first time in years, the question arises as to whether their respective central banks should continue highly accomodative monetary policy, and whether they can wind down stimulus measures in a stable manner (as the Federal Reserve has managed to do).
At the same time, inflation in both regions remains well below central bank targets. Europe has significant slack remaining in its economy (unlike the US), with unemployment remaining well above pre-crisis levels across a large part of the continent. This means there is less pressure on wage growth. The European Central Bank (ECB) is set to begin tapering its bond purchases in January 2018 and may end its quantitative easing program by September. Yet it is unlikely that we will see them start to raise rates in 2018, especially if inflation remains on the lower side.
Japanese inflation, or lack of it, remains a puzzle despite a pickup in growth. Wage growth is flat even though unemployment hit 2.7 percent in November (the lowest since 1993). While the Bank of Japan (BoJ) appears publicly committed to keeping policy as accommodative as possible, for as long as necessary, they recently announced that purchases of long-dated bonds will be trimmed. This immediately sent longer-dated bond yields to their highest levels in a month and the yen appreciated 0.5 percent against the dollar. So markets are clearly sensitive to any sign of tapering and will try to decipher the tea leaves every time the BoJ makes a statement.
Will the US dollar reverse its decline in 2018?
Typically you would expect the dollar to rise amid Federal Reserve policy tightening and tax reform. Exactly the opposite happened in 2017, with the trade-weighted US dollar index (against major currencies) falling 8.6% over the year. Of course, the index is still up almost 15% from the end of 2013 thanks to the massive three-year run up between 2014 and 2016.
One positive side effect of a falling dollar was that net exports did not drag on US GDP growth in 2017 (first three quarters). This is in sharp contrast to the 2014-2016 period when net exports pulled back GDP growth despite strong consumption numbers. So if the dollar reverses its decline in 2018, there is a chance that net exports could be a drag once again – we may even see this in fourth quarter GDP numbers.
The lower US dollar has also given emerging markets (EM) a reprieve from tighter policy in the US, not to mention boosted dollar-denominated returns for foreign equities in both developed and emerging markets. A lower dollar makes it cheaper to service dollar-denominated debt – two-thirds of hard currency liabilities are denominated in dollars. This boosts purchasing power of foreign businesses, leading to even more credit growth (in offshore dollars) and higher real investment returns, especially in EM. In other words, the global economic upswing is feeding off dollar denominated credit, which in turn makes the dollar weakness self-sustaining. This effect tends to overwhelm the traditional trade channel in EM i.e. when a stronger domestic currency leads to a fall in net exports.
So the dollar could find itself under renewed pressure if global growth continues along recent trend. Pushing against this are Federal Reserve interest rate hikes, which also maintains a high yield differential between the US and other developed markets (Europe and Japan). Investment flows into the US on the back of tax reform could also boost the dollar. Though we do note that offshore corporate earnings that may be repatriated are already likely to be reinvested in dollar denominated assets.
How will China manage its rebalancing and deleveraging process?
At the beginning of 2017 we asked the question as to how China will deal with falling reserves and capital outflows. We now know the answer. China posted higher reserves for the 11th straight month in December thanks to strict capital controls. A weaker dollar has also helped reduce pressure on the yuan. China’s economy has held up amid the global recovery, boosting exports.
Yet the reality is that China has not quite begun to rebalance its economy – 2017 performance was highly dependent on manufacturing as opposed to services and domestic consumption. Also, while officials appear to have begun the process of develeraging – putting curbs on financial institutions and the shadow banking sector – debt across Chinese firms (especially non-financials and state-owned enterprises) continues to grow, with levels at the end of September growing at the fastest pace in four years. Overall debt is now more than 300 percent of GDP. It remains to be seen whether authorities will extend the develeraging process beyond financials, and if this can be done without posing a threat to the economy.
Recently the IMF warned China to prioritize financial stability and de-emphasize high GDP projections in national plans, which leads to regional governments setting high growth targets and keeping non-viable firms open (rather than allowing them to fail). Ironically, improved oversight of the banking sector has also led investors looking for high-yield investment products toward more complex investment vehicles in less supervised areas of the financial system.
Tail-risk from North Korea?
A potential tail-risk is the possibility of war in the Korean peninsula. North Korea made significant advances to its missile and nuclear program in 2017, even as they engaged in a war of words with President Trump. Sanctions, including increased pressure from China, failed to reverse North Korea’s buildup. On the positive side, after a year of ignoring South Korea’s new President, Moon Jae-in, who repeatedly called for a thaw in the relationship, North Korea’s leader finally reached out over the New Year to discuss participation in the Winter Olympics (slated to open on February 9th in Pyeongchang, South Korea). These are the first formal talks since 2015. As a goodwill gesture, the US and South Korea also agreed not to hold annual military drills (which North Korea considers a provocation) during the Olympics. It remains to be seen if this is a good faith effort by the North or simply a gambit to drive a wedge between the US and its ally.
At the same time, reports suggest the US is considering a limited ‘bloody nose’ strike – a presumably one-off strike that sends a message to North Korea. However, it does make a rather large assumption that there will be no retaliation, and that really is a guess. Any hostilities between the US and North Korea faces enormous risk, including unimaginably large loss of life. South Korea is also a vital player in global trade and military action in the peninsula will probably cause severe economic disruption across the globe.
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