Global Economy Firing on All Cylinders | Mackenzie Investments

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Global Economy Firing on All Cylinders

From North Korea to the chaotic Trump White House, geopolitical risks made headlines again last quarter. Despite the headline noise, the MSCI World Index returned 3.9% for the quarter in local currency terms. The index has gained for 11 consecutive months dating back to November 2016, which is tied for the second longest string of positive monthly returns since 1970. This performance has benefited our overweight in equities that we implemented heading into 2016 Q4. The MSCI World index is now up by about 19% since we made that recommendation, while bonds are down slightly. Looking ahead, we remain tactically overweight in stocks relative to bonds and expect the Canadian dollar to strengthen further.

Asset Mix: Global economy in high gear, supporting global stocks

We expect the global economy will continue growing above-trend with low inflation this quarter, supporting stocks relative to lower-risk government bonds. China and the US should continue to lead the synchronized global expansion as the two engines of the world economy. Three factors have driven the global expansion and reflation since mid-2016 (Chart 1):

  1. Credit and infrastructure stimulus in China helped revive world trade and commodity prices.
  2. Global manufacturing activity and consumer confidence rebounded sharply.
  3. The surprise election of Donald Trump boosted expectations of pro-growth reforms, including deep tax cuts, infrastructure and deregulation.

U.S. Leading Economic Indicators

Source: Market data for the S&P 500 stock index and the Conference Board’s index of U.S. Leading Economic Indicators provided via Bloomberg. Annual stock returns and leading indicators expressed as a 3-month moving average.

Today, most major economies enjoy strong growth compared to the last five years (Chart 2) and the expansion looks set to continue. Tax reform in the US is likely to be modestly expansionary while China's leadership will likely deliver above-target growth, particularly ahead of the National Party Congress this year. While the US economic cycle is the most advanced, other major economies are catching up, leaving room for the current global expansion to run:

  • The euro zone has been remarkably resilient to political shocks. The loose monetary stance, reduced fiscal austerity and recovery in domestic demand should support steady job gains.
  • Japan is also expected to grow above trend, benefitting from a weak yen, strong consumer spending and public investment, and ultra-loose monetary policy.
  • Major emerging markets, including Brazil, Russia and South Africa, are benefiting from improved commodity prices and easing access to foreign capital.

Both global stocks and bonds appear richly valued relative to long-term valuation models. However, we believe that equity valuations remain relatively attractive in today's low interest rate environment against bonds. In addition, stretched valuations often matter most when the business cycle begins to turn, and right now, the global economy is growing above-trend in a synchronized fashion.

Strong Global Growth Well Synchronized

Source: Quarterly data on real GDP in annualized growth rates provided via Bloomberg.

Tightening global monetary conditions could put modest upward pressure on bond yields

While steady global growth is expected to support the stock market, tighter global monetary conditions provide a bearish backdrop for bond markets. The US Federal Reserve will begin reducing its US$4.5 trillion balance sheet in October. At the same time, we expect the ECB to begin tapering its QE program in January 2018. Other major central banks are also expected to tighten in 2018, including the Bank of Canada and Bank of England.

As central banks gradually tighten monetary policy and unwind QE over the next few years, we expect modest upward pressure in term premiums (that is, the extra compensation demanded by investors for holding long-term bonds). Term premiums currently stand near historic lows, having declined sharply after 2008. However, upward pressure on bond yields is expected to be modest and gradual for several reasons:

  • Central banks will reduce their balance sheets more slowly than they expanded them.
  • At the end of this process, central bank balance sheets are likely to remain much larger than before 2008 (i.e., the Fed may stabilize its balance sheet to around US$2.5 trillion compared to less than US$900 billion before the 2008 global financial crisis).
  • As central banks reduce their bond holdings, other investors are likely to step in, given the scarcity of risk-free assets, including commercial banks, pension funds and reserve managers.

Currency: Loonie expected to strengthen

Investor enthusiasm for the Canadian dollar is expected to persist this quarter as investors anticipate higher interest rates given above-trend economic growth this year. The Canadian economy grew at the fastest pace among G-7 countries in Q2. With the economy growing solidly above trend, and spare capacity expected to be fully absorbed later this year, the Bank of Canada has already hiked overnight rates twice since June with the market pricing-in roughly even odds of a third hike by December. We expect that tightening monetary policy together with above-trend economic growth will continue supporting the Canadian dollar (Chart 3).

Canadian Monetary Conditions Have Tightened Rapidly Since June

Source: Change in 2-year government bond yields and spot exchange rates relative to the US dollar from June 1 to September 26, 2017. Market data provided via Bloomberg as of September 26, 2017

In contrast, the outlook for Fed policy is uncertain in 2018. The Fed’s senior leadership could change significantly with multiple vacancies on the Fed’s board. President Trump may also replace Janet Yellen as Fed Chair. In addition, Fed doves may point to persistent weakness in the Fed’s preferred gauge of inflation, providing ammunition for a slower pace of US rate hikes.

Overseas, the Bank of Japan continues to maintain its ultra-loose monetary policy and shows little sign of pulling back like other major central banks. The BOJ’ actions to keep 10-year interest rates close to 0% and buy large amounts of exchange traded funds should maintain pressure on the weak yen.

In considering these trends, we have a bullish outlook for the Canadian dollar against the US dollar and Japanese yen.

Relative Equity: Expect a challenging environment for Canadian equities

Even though we view economic and inflationary trends as supportive of stocks in general, not all equity markets are expected to gain equally. Despite headline news of impressive GDP growth and a strong loonie, these factors are actually expected to be headwinds for Canadian equities in the near term. As a result, we are moderately underweight the Canadian market relative to other stock markets.

Recent GDP growth has pushed growth expectations significantly above our estimates of potential or long-run growth (Chart 4). Given the degree to which GDP has exceeded expectations, we believe that sustaining this growth is unlikely (Chart 5). Should realized GDP growth disappoint investors, we may experience downward pressure in Canadian stocks. In addition, since 30% of Canada’s economy is export-based, a stronger loonie should dampen the profit outlook of companies with export revenues.

GDP Growth Forecasts Way Above Long-term Potential

Source: Consensus Economics survey of forecasters for 2017 Canada real GDP as of September 2017. Canadian potential growth estimated by Mackenzie’s Asset Allocation and Alternatives team based on forecast of labour supply growth, capital accumulation and total factor productivity growth.

Hard to Sustain Current Pace of Positive Economic Surprises

Source: Bloomberg, Citi Economic Surprises Index for Canada from December 2008 to August 2017

Global Investment Committee’s Asset Allocation and Currency Outlook, 2017 Q4

  Underweight Neutral Overweight
Strong Moderate Slight Slight Moderate Strong
Equities vs. Fixed Income           Current Views (as of Oct. 3, 2017)  
US       Current Views (as of Oct. 3, 2017)      
Canada   Current Views (as of Oct. 3, 2017)          
Europe       Current Views (as of Oct. 3, 2017)      
U.K.       Current Views (as of Oct. 3, 2017)      
Japan       Current Views (as of Oct. 3, 2017)      
Emerging         Current Views (as of Oct. 3, 2017)    
USD   Current Views (as of Oct. 3, 2017)          
EUR       Current Views (as of Oct. 3, 2017)      
GBP     Current Views (as of Oct. 3, 2017)        
JPY   Current Views (as of Oct. 3, 2017)          
● Current Views (As of Oct. 3, 2017)
* Refers to local currency index; Emerging is MSCI EM Index

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