Q3 Outlook 2017: Steady Global Growth Sets a Bullish Backdrop
Todd Mattina Chief Economist and Strategist on the Mackenzie Asset Allocation Team
With the high water mark of the ‘Global Reflation Trade’ moving further into the rear-view mirror, the global economy appears to be shifting gears. The Global Reflation Trade refers to investors positioning for an increase in stocks, bond yields and the US dollar in anticipation of expanding global growth and inflation. Three pillars drove the Global Reflation Trade beginning in mid-2016. These include a strong rebound in global manufacturing activity and world trade, a sharp jump in business and consumer confidence, and the surprise election of Donald Trump with high expectations for deep tax cuts, higher infrastructure spending and deregulation. As the influence of these pillars faded, the acceleration in global growth slowed.
The Global Reflation Trade stalled after its peak in December 2016 (Chart 1). Several factors have been at play. First, China tightened its macroeconomic policies in 2017 by dialing back the unsustainable pace of debt accumulation following an increase by almost 100% of GDP since 2008. In 2017 Q1, China's aggregate financing totalled about $1 trillion US, underpinning the rebound in world trade and commodity prices. Second, US economic momentum slowed in the first quarter of 2017, owing to weak consumer spending and a decline in government outlays. Third, the chaotic White House was unable to advance President Trump’s agenda in the Republican-controlled Congress, raising questions about the feasible size and timetable of passing tax cuts.
Looking ahead, the global economy is expected to shift into a new phase of stable and steady growth after the rapid reflation phase since mid-2016. The shift in the economic outlook differs across regions with slower growth in the US and stronger prospects in other regions, including Canada:
- Moderating US outlook. While President Trump’s pro-growth policy agenda initially raised hopes of a strong expansion in economic activity, the growth outlook in 2017–18 remains steady at about 2.2% due to dimming prospects of large tax cuts or sharply higher infrastructure spending. Congress must first contend with a crowded legislative agenda and distractions linked to possible electoral interference by Russia and improprieties by President Trump. Congress also needs to agree on a new debt ceiling by September/October to prevent a government shutdown and finish work on the healthcare reform. At the same time, the Fed anticipates two additional rate hikes in 2017 and 2018 along with a gradual reduction in its $4.5-trillion US balance sheet to unwind quantitative easing (QE). However, we expect inflation to remain below the Fed’s 2% target in 2017, leading to about two hikes by the end of 2018, roughly in line with current market pricing.
- Resilient Eurozone and steady Japan. In contrast to the US, economic activity in the Eurozone remains well above its long-term trend, as growth reached 1.9% in 2017 Q1 and possibly reaching 2% for the year. Economic growth has been supported by subsiding political risk related to anti-establishment parties, continued loose monetary policies, reduced fiscal austerity and an improving labour market. Growth in Japan of 1% in 2017 Q1 also exceeded its long-run trend of about 0.6%, as ultra-loose monetary conditions and the weak yen supported net exports and solid consumer spending.
- Canadian rebound. The cyclical rebound accelerated in Q1 after the slowdown in the last two years, prompting a more hawkish tone by the Bank of Canada given the improved outlook. Economic growth reached 3.7% annualized in 2017 Q1, led by consumer spending and residential construction, as gains in home prices stimulated higher household spending. The adjustment in the oil patch to structurally lower energy prices could be nearing an end, as business investment stabilized following large declines in 2016. The federal fiscal stimulus also supports an expected steady improvement. Unfortunately, Canada’s strong growth rate remains overly loaded on sources of long-run vulnerability, such as the over-valued housing market and over-leveraged households. The rebalancing of growth into non-energy exports also remains elusive.
- China cooling down. Robust credit expansion in 2016 and early 2017 supported strong housing construction and infrastructure investment, contributing to rapid growth of 6.9% in 2017 Q1. Policy makers are cooling the economy with moderately tighter macro policies, including higher interest rates and a slower pace of credit expansion. Armed with substantial policy buffers, China’s leadership is expected to deliver steady growth of about 6.6% in 2017, which would be slightly ahead of the official annual target. In this context, moderating economic activity in China is not expected to lead to a sharp reversal in world trade.
Steady economic growth and modest inflationary pressure provide a bullish backdrop for risk assets. In terms of the asset mix, stocks are expected to continue outperforming government bonds. While expected stock returns are lower in this phase of the cycle, we still expect stocks to be rewarded over risk-free bonds. In terms of relative equity markets, we expect the US stock market to underperform as investors reassess the relative policy and cyclical outlook, rich starting valuations and high expectations on President Trump to deliver pro-growth policies. In particular, emerging markets and the UK stock market are expected to outperform given relatively attractive valuations.
The main uncertainty going forward is the increasingly hawkish tone taken by major central banks. The Fed anticipates two further rate hikes in 2017 and 2018 despite sluggish inflation and wage growth; however, steady rate hikes and uncertainty about the unprecedented unwinding of QE could tighten financial conditions more than desired. Mario Draghi also increased uncertainty about possible ECB tightening later this year by pointing out that reflationary risks have replaced deflationary risks in the Eurozone. The Bank of England and Bank of Canada also surprised markets with more optimistic outlooks and hawkish overtures about the rate outlook; however, hiking real interest rates prematurely risks slowing the global expansion. For this reason, central banks will keep a close eye on incoming inflation data this quarter while monitoring for signs of excessive exuberance in asset markets that could justify tighter policies.