The Outlook for Interest Rates, the Economy and Inflation in the U.S. and Among the Other Major World Economies

The U.S. Fed will probably start shrinking its balance sheet in September and the ECB is likely to taper its asset purchases in the first half of 2018. What is the outlook for interest rates, the economy and inflation in the U.S. and among the other major world economies?

Beginning with the United States, data indicates that the Fed’s balances sheet may remain substantially higher for longer and that interest rates may remain substantially lower than would have been considered normal before the crisis.

In the twenty years ending 2007, Fed funds averaged 4.85%¹. In September 2007, the Fed started cutting interest rates until it reached 0.25% in December 2008¹. The Fed wasn’t ready to cut further into negative rate territory which left them with an economy needing stimulus while their preferred tool was exhausted. Instead, the Fed embarked in Quantitative Easing (QE), large-scale asset purchases, which dramatically expanded its balance sheet.

Though the Fed has not added to its balance sheet since 2014, it has been reinvesting the interest and principal payments received to maintain the balance sheet at a steady level. Asset purchases as a monetary policy tool is new in the U.S. and allowing the assets to mature may have an unknown affect on the economy.

There is a risk of tipping back into recession if the unwinding begins when growth is too weak. The Fed’s normalization statement pointed out that while it expects to use the federal funds rate to fight recessions, the FOMC may restart reinvestment in the event of substantial interest rate cuts.

After the Fed reduces its balance sheet, rates would likely remain low. The U.S. trend growth rate is believed to be about 2% per year. The FOMC’s poll of its own voting members expects longer-run growth to be in the range of 1.8-2.0%, which is in line with the trend growth rate. For comparison, for 20 years ending 2017, GDP annual growth averaged about 3%¹.

As we discussed in our White Paper 3, the expectation for lower average growth in the years ahead is due to low productivity growth and the aging demographic. The productivity slowdown is a new phenomenon that is not entirely understood and it is possible that productivity acceleration could result in a pick-up in growth eventually. For now, slower trend growth will contribute to lower interest rates in the years ahead than in the period before the crisis. The aging U.S. population is also a factor as increased savings make their way into the fixed income market.

 

Themes

1.  A Mixed World Economic Outlook

Advanced economies grew fairly rapidly in the second quarter, with GDP growth likely to have rebounded strongly in the U.S., Japan and the UK and to have accelerated a little in the euro-zone. This in turn has led to a further reduction in the aggregate unemployment rate in advanced economies. However, there is little sign that wage pressures are rising.

While Japan and the UK saw downward revisions to Q1 growth, the economic growth in the euro-zone was revised up. The euro-zone has now recorded three consecutive quarters of accelerating GDP growth. The recovery in advanced economies as a whole has been driven largely by consumption. Investment spending has also recovered in nearly all major advanced economies, but particularly in the U.S. and euro-zone. Industrial production has generally expanded at a decent pace in recent months. Among the emerging economies, China growth edged up in May for the first time this year.

A synchronized shift in monetary policy swept across bond markets in June with hawkish central bank chatter pushing bond yields higher across Canada and Europe. These moves spilled over to the U.S. bond market despite the slow-moving Republican agenda, soft economic results, and muted pricing pressures.

Global monetary conditions remain loose despite continued tightening by the U.S. Fed. Policy rates in major advanced economies are still exceptionally low. Policymakers in the ECB, Bank of England and Bank of Canada made comments prompting a sell-off in bond markets towards the end of the quarter, but the increase in bond yields was small compared to the move after the election of Donald Trump.

Growth in lending to firms has been steady in the euro-zone, at about 2% year over year². However, there are big differences within the region with lending still contracting in Italy, reflecting the weakness of its economic recovery and the country’s troubled banks.

The Bank of Canada shows confidence in the Canadian economy by raising rates by 0.25% to 0.75% in July and signalling further removal of policy stimulus in the future. Canada has been a leader of major changes in the global monetary system in the past. In 2015, its rate cuts helped kick off a global trend that saw countries accounting for almost half of global output including China, Denmark, Sweden, Indonesia and Australia. Canada is in the midst of one of its strongest growth spurts since the 2008-2009 recession, with the expansion accelerating to over 3% over the past four quarters³.

The Bank of Canada highlighted in its statement that the recent economic data has bolstered their confidence in the “economic outlook for above-potential growth and the absorption of excess capacity in the economy.⁴” Low borrowing costs are fuelling housing prices and household debt is hovering at record levels. Similar to the United States, the labour market has been strong, with the unemployment rate at the lowest since before the recession. Though inflation has not increased, the Bank determined that recent softness in inflation is only temporary and that it will rebound.

The collapse of oil prices that trimmed $60 billion annually off Canada’s national income prevented the Bank from following the Fed in raising rates beginning 2015³.

The Canadian economy appears to be on the verge of a slowdown due to housing-related weaknesses, which is reinforced by higher household borrowing costs. The surging Canadian dollar over the past month as the U.S. dollar weakened would also add to the shift to tightening. The same questions around stagnant inflation apply in Canada and elsewhere.

 

2.  U.S. Growth Slows:  Delayed Fiscal Stimulus and America Alone

Sentiment in the United States economy contradicts recent economic data. While businesses and consumers are positive about the future, economic activity has not been coming in strong. Several surveys report that chief executive officers are highly optimistic, however, M&A activity is at its lowest level since 2013, and has fallen 40% in the past two years⁵.

Share buybacks has slowed and capacity usage has fallen, both indications that CEOs are less confident in the future of their businesses. The University of Michigan’s Surveys of Consumers show confidence at the highest levels since before the crisis. Meanwhile, retail sales fell in May and have been relatively lackluster for the year so far⁵.

The drop back in core PCE inflation to a 17-month low of 1.4% in May has led to expectations that the Fed will hold on raising interest rates⁶.

The Fed’s 2% inflation target looks more like a ceiling since core PCE inflation has only exceeded that level 24% of the time since 1995⁶. Core inflation has been above target only 6% of the time since the target was adopted in 2012⁶.

As we discussed last quarter, a fundamental shift in trade policy over the next four years is being proposed by the new administration to stem the further outsourcing of manufacturing production and employment abroad this year.  The reality is that only a small fraction of the five million lost jobs could conceivably return since China’s shift 15 years ago to largest importer to the WTO. Additionally, assuming the U.S. becomes more aggressive in initiating disputes at the WTO, other countries could retaliate by bringing their own claims. Meanwhile, the boost to the domestic manufacturing sector should be minimal if these new trade policies trigger a further appreciation in the dollar.

 

3.  Global Low Yield Environment Ends Unevenly

The U.S. Fed will probably start shrinking its balance sheet in September and the ECB is likely to taper its asset purchases in the first half of 2018. The U.S. reflation trade has been delayed by muted wage growth and uncertainty about fiscal policy, but the prospect of ECB normalization is now pushing global yields higher.

The biggest impact of globalisation on interest rates driven by inflation has come through the deflationary effect on traded goods prices, particularly durable goods prices, which have been declining since the late 1990s.

The flattening of the Phillips curve is usually attributed to globalisation, well-anchored inflation expectations, the decline in union power and increases in labour flexibility. This is a global phenomenon. In addition to the United States, low unemployment rates in the UK, Germany, Japan and Canada have failed to spark any meaningful acceleration in either wage growth or core price inflation. Globalisation has undoubtedly played a key role, particularly the entry of China into the global economy.

While China has been an integral part of the global trading system for more than a decade now, the rate of decline in goods prices shows no signs of easing. As a result of globalisation, goods prices now tend to be driven by global economic factors, as much as domestic U.S. factors, which contributed to the flattening of the Phillips curve. However, globalisation and technical progress have had a much smaller impact on services prices.

The rate of service price inflation fell sharply during the 1980s and early 1990s, but that was mainly due to better anchoring of inflation expectations, as the Fed built its credibility as an inflation-fighting central bank. Since the mid-1990s, services price inflation has been more stable. Most recently, housing and other services inflation has been accelerating as expected given the gradual elimination of slack in the labour market. However, health care price inflation has continued to trend lower, which accounts for almost 20% of the core PCE⁶. This explains why core PCE inflation appears to have reacted less to shifts in the output gap in recent years.

 

4.  U.S. Dollar Depreciation

The US dollar has continued to depreciate on a trade-weighted basis in recent weeks, despite another increase in the federal funds rate. It is now around 5% lower than its value at the turn of the year. In June, it fell against all major advanced-economy currencies except the yen. We expect this to continue as the implications of the United States no longer leading in coordinating global trade and climate change, and as fiscal stimulus is delayed due to political headwinds are factored into the currency price.

With these themes in mind, we will continue to monitor economic data for traditional slow growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics.

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

July 15, 2017

 

¹ ETF Trends.com, Fed Outlook H2 2017, July 7, 2017.

² Capital Economics. Global Economics Chart Book. July 6, 2017.

³ Bloomberg.com. Your Guide to the Bank of Canada’s Bellwether Rate Decision. July 12, 2017.

⁴ Capital Economics. Canada Rapid Response. July 12, 2017.

⁵ Bloomberg.com. Why Americans Feel So Good About a Mediocre Economy. June 26, 2017.

⁶ Capital Economics. US Economics Weekly. July 7, 2017.

In June, we continued with our global Stagnation Outlook for the twelve-month forward period. Although growth was lower than expected in Q1 in several G7 economies, a slow expansion is now well established across the board. That said, some of these economies have made a much better recovery from the crisis than others.

The European Central Bank’s dovish policies have depressed the value of the euro and boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result, wages in central Europe are rising and inflation is accelerating.1

Meanwhile, global core inflation, which has remained stable at a 2% pace in recent years, also slipped this quarter to an estimated 1.7%, raising concerns that it will be more difficult to lift inflation back toward central bank targets.  The recent downshift in China has been a source of concern particularly as it has been mirrored across Asian industry. Global credit conditions remain supportive despite a slowdown in the United States. The latest data on bank lending point to downward pressure on GDP growth in advanced economies, although the slowdown in credit growth has been concentrated almost exclusively in the United States.

After a disappointing 1.2% annualised gain in Q1, U.S. GDP is on track to rise in the second quarter. Industrial production has rebounded in recent months, helped by the continued turnaround in activity in the mining sector. After hitting a 5-year high of 2.7% earlier in 2017, headline CPI inflation has fallen back to 1.9%, due mostly to the recent decline in energy prices.  Core inflation has also slowed in recent months with the annual rate falling to 1.7% in May and the 3-month annualised rate plunging to a 7-year low of zero. There is widespread weakness in core inflation. Despite the Fed raising interest rates again in June and reiterating its plans to continue gradually tightening policy, it appears that markets are pricing in only one 25bp rate hike by the end of 2018. The 10-year Treasury yield has declined even though there were three rate hikes since December last year. The dollar has also continued to decline, with the Fed’s trade-weighted dollar index having now completely reversed its prior surge following last November’s presidential election. Furthermore, the stock market has continued to weather the Fed tightening.

The month of May saw mixed results across U.S. equities. The S&P 500 gained 1.4% while S&P SmallCap 600 lost 2.1%. International equity markets performed well as the S&P Europe 350 gained 4.9%, S&P Asia 50 gained 4.8% and S&P Emerging BMI gained 1.7%. Meanwhile in Canada, the S&P/TSX Composite lost 1.3%. U.S. fixed income markets were positive in May. Municipal bonds were the top performer with the S&P National AMT-Free Municipal Bond Index returning 1.4%. Commodities ended May poorly with the S&P GSCI losing 1.5%. The combination of the lukewarm investor response to OPEC extending its restriction on production and the news that a rise in Libyan output had increased production among OPEC countries for the first time this year sent the S&P GSCI Crude Oil index down 2.8%.2

We rebalanced in June to reflect our continued Stagnation outlook. Across all models, we replaced U.S. Small Caps with U.S. Large Caps in response to the postponement of corporate tax reform that is now better reflected in Large Cap valuation. We maintained Canadian and European Equity exposure as well as the long-term U.S. Treasury Bond. Financial conditions appear more accommodative since late last year due to lack of evidence of inflation in the U.S. despite Fed rate hikes. Our shift to long bonds reflects our view that this may not reverse in the near-term. For more insight into our views on the changing impact of inflation, see our most recent White Paper: A Regime Change Underway, available on our website.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

Deborah Frame, President and CIO
Data Source: Bloomberg

 

 

[1] BCA. Emerging Markets Strategy – Central Europe: Beware of An Inflation Outbreak (Special Report), June 21, 2017.

[2] Index Returns: S&P Dow Jones Indices Index Dashboard: U.S., Canada, Fixed Income. May 2017.

In May, we continued with our global Stagnation outlook for the twelve-month forward period. The outlook for the world economy is improving and world trade has picked up. Manufacturing conditions in advanced economies are improving and point to a rebound in economic growth in Q2.

The recovery in the euro-zone has gained momentum after being captivated by the closely-fought first round of the French elections in April and the second round on May 7 that brought considerable relief. The flash composite PMI for the euro-zone stayed at its highest level in six years and the composite PMIs for Germany and France reached six-year highs1.  As the remaining European Union nations present an increasingly unified front ahead of the upcoming “Brexit” negotiations, the medium-term economic outlook for the U.K. weakened while the prospect of a big win for Theresa May’s Conservative party in a general election slated for June 8th helped the British pound strengthen.

The U.S. looks set to hold back from extreme protectionist policies, and any changes to NAFTA seem slow to materialize. Although the Trump administration claims that external trade is a drag on economic growth, for the past five years the monthly trade deficit has been broadly unchanged in dollar terms. That said, the goods trade deficit widened slightly in April, as exports declined by 0.9% m/m and imports increased by 0.7% m/m2. The decline in exports was driven by a 7.5% m/m slump in automotive exports and a 4.5% m/m fall in consumer goods exports3.

The slowdown in Q1 GDP growth to just 0.7% annualized resulted from lower government spending and inventories4. Investment spending added 1.7% to growth, its largest contribution in five years5. The recent weakness in inflation and the political dysfunction that threatens to delay tax reform have resulted in only a modest decline in interest rate expectations. Monetary policy looks set to diverge from other major economies as the U.S. Fed continues to prepare investors for future rate hikes. Headline CPI inflation remains elevated, yet core inflation was unexpectedly weak in both March and April, bringing the three-month annualized core inflation rate to a six-year low of only 0.6% in April6.  The headline unemployment rate declined to a 10-year low of 4.4% in April, a level that would typically cause the Fed to behave hawkish7. However, wage growth remains at a low of 2.5% year over year8.

U.S. Equity markets were positive this month with the S&P 500 gaining 1.0% and S&P 600 Small Cap gaining 0.9%. International equity markets performed well in April with S&P Developed Ex-U.S. BMI and the S&P Emerging BMI both up 2%.

April results for U.S. fixed income returned to positive territory, with the S&P Preferred Stock index as the top performer, up 1.2% for the month. All the aggregate’s components had positive returns; S&P Taxable Municipal Bond Index up 0.9%, and S&P Investment Grade Corporate Bonds up 1.2%. The S&P U.S. High Yield Corporate Bond Index returned 1.1% for April.

Commodities performed poorly, driven by continued weakness in Energy, while the current increased level of geopolitical risk resulted in gold prices benefiting from the asset’s status as a safe haven.

We rebalanced the portfolio models in May to reflect our continued Stagnation outlook. Across all models, we lowered exposure to U.S. Small Cap and Canadian Equity, added to European Equity and a new position in Long-term U.S. Treasury Bonds. Financial conditions have become more accommodative since late last year, even though the Fed has hiked its policy rate twice during that time and our shift in the direction of long bonds reflects our view that this will not be unwinding in the near-term.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

Deborah Frame, President and CIO
Data Source: Bloomberg

 

[1] Capital Economics, Global Economics Data Response. May 23, 2017.

[2] Capital Economics, US Rapid Response. May 25, 2017.

[3] Capital Economics, US Rapid Response. May 25, 2017

[4] Capital Economics, United States Chart Book. May 17, 2017.

[5] Capital Economics, United States Chart Book. May 17, 2017.

[6] Capital Economics, United States Chart Book. May 17, 2017.

[7] BLS.gov

[8] BLS.gov

In April, we continued with our global Stagnation outlook for the twelve-month forward period. After a lackluster showing in 2016, economic activity in emerging and developing economies is projected by the International Monetary Fund to pick up the pace in 2017 and 2018. There is a wide dispersion of possible outcomes, however. Persistent structural problems such as low productivity growth, binding structural impediments and existing policies are increasing in advanced economies. These threaten global economic integration and the cooperative global economic order that has served the world economy in both emerging market and developing economies.

A long-awaited cyclical recovery in global manufacturing and trade is underway. The IMF predicts that world growth will rise from 3.1% in 2016 to 3.5% in 2017 and 3.6% in 2018. Eurozone economic data has been encouraging so far, and the uptrend in capital goods orders bodes well for investment spending. Private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. The unemployment rate has fallen and there is less spare capacity in European labor markets today than when the U.S. Fed first hinted at tapering its asset purchases in 2013. Other encouraging data shows the outlook for France is improving despite uncertainty about the outcome of the presidential election there.

In the United States, manufacturing activity has been strengthening in recent months, largely because the drag from the past appreciation of the dollar has faded. Prospects for stimulative tax cuts and infrastructure spending, along with the fears of blowing out the budget deficit, all seem to have been pushed further back in the time horizon for the U.S. economy. The decline in core consumer prices in March, the first monthly fall in seven years, may be a signal of underlying weakness in the real economy. The key message from the March Fed meeting may be at odds with this trend, as they now believe that inflation has finally reached its 2% target.

U.S. equities were flat in March as the S&P 500 gained 0.1% and S&P SmallCap 600 declined by 0.1%. The S&P 500 dispersion recorded its second-lowest monthly reading for a decade1. The present low dispersion coincides with lower correlation and much lower benchmark volatility than in July 2011, the last time dispersion was this low. Similar trends are seen globally, with low benchmark volatility, moderate-to-low correlations, and low dispersion. U.S. Small Caps and Latin America are exceptions to this trend, while Japan’s equity market continues to show higher correlation than its peers.

The Fed’s announcement of another interest rate hike negatively affected most fixed income sectors. March results for U.S. fixed income were flat or negative, with the broad S&P U.S. Aggregate Index down 0.04% for the month.  Mortgage backed securities and Preferred bonds posted positive returns for the month. Outside the U.S., International equity markets performed strongly in March.  Canadian equities were positive, with the S&P/TSX Composite TR Index up 1.3%. In Europe, the S&P Europe 350 TR gained 3.4%. The MSCI United Kingdom increased 1.7%. The European Central Bank’s hawkish tone at its March meeting indicated that tighter monetary policy was coming, causing most European bond indices to fall in March.

We rebalanced the portfolio models in April to reflect our continued Stagnation Outlook, while factoring in the relative opportunities in International Equities.  We reduced U.S. Mid Caps and Small Caps in all models. Exposure to Australia was eliminated in the Conservative and Moderate Growth models and reduced in the Growth and Aggressive Growth Models, as the early March positive revision from the IMF benefited the Australian equity market disproportionately relative to Europe. Exposure to Europe was initiated in the Conservative, Moderate Growth and Growth models and increased in the Aggressive Growth portfolio.  Exposure to fixed income was increased across all models including reinitiating exposure to Municipal Bonds in the Aggressive Growth portfolio model.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

Deborah Frame, President and CIO
Data Source: Bloomberg

 

[1] S&P Dow Jones Indices.  Index Dashboard: Dispersion, Volatility & Correlation.  March 31, 2017.

When does inflation begin to change investment decisions?

During the first quarter of 2017 we removed U.S. inflation from our outlook and reverted to Stagnation for all global economies for the twelve-month forward forecast. Looking to the future, our analysis suggests that ongoing monetary accommodation is unlikely to have significant inflationary consequences, if inflation expectations remain anchored. As we enter the second quarter of 2017, we are redefining our Inflation environment to U.S. CPI1 greater than 3.5%, up from the previous 2.7%. We will review this as the economy grows, and as underlying inflation and interest rates move higher.

With U.S. macro data coming in strong and further evidence that price pressures are building, the uptrend in bond yields appears likely to continue.  As the focus of rising yields is primarily to manage the rate of growth of an economy and inflation, we believe it worthwhile to review the traditional and current relationships between growth, productivity, inflation, bond yields and equities. The recent rising trend in bond yields has been positively correlated with continued gains in equities, which we relate to a low inflation environment.

Advanced economies have experienced a prolonged episode of low interest rates and low growth since the global financial crisis. From a longer-term perspective, real interest rates have been on a steady decline over the past three decades. Despite recent signs of an increase in long-term yields, particularly in the United States, the experience of Japan suggests that an exit from a low interest rate environment does not come with a play book. A combination of slow-moving structural factors, including population aging and slower productivity growth currently plaguing many advanced economies, are generating a steady state of lower growth and lower nominal and real interest rates in these countries. With the second Fed hike in December and the expectation that the Fed will soon begin to shrink their bond portfolio, the market will judge whether the tighter financial conditions will impact growth. Challenging the impact of the rate hike is the impact of the stronger U.S. dollar.

U.S. Payroll employment started the year on a strong note, with monthly gains in both January and February well above 200,0002.  Rising labour costs helped drive core inflation above 2% but these costs are rising faster than selling prices in the non-financial corporate sector.  Is the U.S. economy growing fast enough to support higher interest rates?

Expansion of central bank balance sheets has produced a multiplier effect on U.S. equity returns. This has impacted confidence which fed into soft data, namely business and consumer confidence, the measures of expected growth for the U.S. economy and inflation. Hard data, such as payrolls and industrial production, have not been as encouraging. The gap between “hard” and “soft” data measuring the U.S. economy has never been wider3.

 

Rising Yields from Low Levels Remain Friendly for Equities

A slowdown in productivity tends to be deflationary at the outset and inflationary later. Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also reduces consumption, as households absorb smaller real wage gains. Stabilization of inflation may imply a shift in economic volatility to other variables, helping generate asset-price booms by making borrowing and risk-taking more attractive. It may also raise the return to capital by restraining wage growth.

 

There is good reason to question the view that lower unemployment will push wage growth substantially higher in the current environment.

 

 

Such results could be explained by the fact that in a very low yield environment, higher yields are perceived as an indication that the economy is improving, which also benefits equity prices. Central banks have debated what the inflation target should be. The first inflation target was adopted by the central bank of New Zealand in 1990. The Fed used an unofficial inflation target until January 2012, when it announced that it thought a policy which targets a 2% rate of inflation is consistent over the longer run with the Fed’s mandate4.  Looking ahead, three structural forces look set to keep us in this low yield environment over our forecasting time horizon of the next twelve months; technical change, flexible labour markets and globalization. We examine this question in further detail in our third Whitepaper available on our website.

 

How should the Fed respond?

Two Federal Reserve Board economists, Michael T. Kiley and John M. Roberts, suggested three ways for the Fed to avoid zero interest rates as much as possible5. We prefer their suggestion to set the inflation target above 2% with the Fed keeping an eye on the weighted impact of all capacity constraints currently present. This is based on our recent conclusion that structural forces will prolong the deflationary forces currently in play.

Headline inflation in the developed world is likely to rise in early 2017, due largely to rising oil prices and a generally firmer global backdrop. Underlying inflation would rise slower as above-trend growth eats away at available slack. Interest rates will likely remain low in many economies, and will not rise substantially in the U.S. in the coming years.  A year ago, a drop in aggregate demand caused a decline in global goods prices.  Stimulus from the BOE, ECB and BOJ was used to fight this trend and contributed to growth.

The recent rebound in inflation is attributed to previous falls in oil prices, a process which has now almost finished. Long-term inflation expectations pulled back in most advanced economies over the past month while headline CPI inflation in major emerging economies continued to fall in February. Emerging markets still struggle while bigger economies are stabilizing.

We conclude that pressures on productivity and demographics will keep inflation pressures and growth in the U.S. and globally at levels within our Stagnation Environment definition for a period extending well beyond our twelve-month forecast horizon.

 

Themes

1.  A Brighter World Economic Outlook

The world economy has entered Q2 in better shape than it exited 2016. It has now been confirmed that global GDP growth accelerated in each quarter of 2016 and was close to 4% in Q4. However, there is still notable divergence in performance among G7 economies. The United States, U.K. and Germany grew by an expected 2% annualized in Q1, while France and Italy are expected to have grown at around half that pace.  In the euro-zone, production grew by nearly 1% in January, and industrial output in Japan has surged over recent months.  The latest output data for the major emerging economies have been mixed. GDP trackers point to a renewed downturn in Russia while information out of China suggests that the improvement in growth seen over the past year or so has fizzled out.

Headline inflation has rebounded in every major economy. In developed markets, monetary easing is on it’s way out while emerging market central banks plan to continue cutting their policy rate.  Among central banks this year, 13 have cut their interest rates while five have raised them6. The unweighted global average policy rate dropped below 2%, an all-time low, while world inflation jumped to 2.5% due to energy prices, resulting in negative real global policy rates7.

The unemployment rate in the OECD fell to 6.1% in January, its lowest since 20088. Employment growth has slowed in the U.K. in recent months, but has continued at a steady pace elsewhere. Euro-zone employment has finally recovered to levels seen prior to the global financial crisis.

The IMF published its twice-yearly health check on the world economy. The outlook has brightened considerably since an interim forecast in January. Signs of stronger activity are visible in both developed and emerging markets. Forecasts for worldwide GDP growth are expected to be revised upwards.  Christine Lagarde of the IMF recently noted that after six years of disappointing growth, the world economy has a “spring in its step”. The outlook could be revised because of political uncertainty (Marine Le Pen might win in France), protectionism (Donald Trump might start a trade war) and tighter global financial conditions (the Fed might raise interest rates too quickly).  For the first time since the recession, there are a lot of things going well.

 

2.  U.S. Growth

The latest data indicate that first-quarter GDP growth was relatively subdued at 2% annualised. That said, a lot of the weakness can be traced back to a sharp drop in utilities demand stemming from the unseasonably mild winter. The sudden post-election weakness in bank lending is a concern. Most of the market and media attention has focused on business loans which, after growing at a double-digit annualised pace between 2014 and late 2016, have suddenly stagnated while other major loan categories also show a marked slowdown in growth since last November.

A fundamental shift in trade policy over the next four years is being proposed by the new administration to stem the further outsourcing of manufacturing production and employment abroad this year.  The reality is that only a small fraction of the five million jobs lost since China’s shift fifteen years ago to largest importer to the WTO could conceivably return. Also, assuming the U.S. becomes much more aggressive in initiating disputes at the WTO, we would expect other countries to retaliate by bringing their own claims. Meanwhile, the boost to the domestic manufacturing sector should be minimal if these new trade policies trigger a further appreciation in the dollar.

Changes to U.S. fiscal policy are not expected to take effect this year, eliminating their potential boost to growth. The combination of proposed fiscal stimulus and higher trade barriers in 2018 will likely add to inflation expectations but this may be offset by changing technology, labor markets and unstoppable globalization.  American companies with large global footprints will suffer relative to domestically focused firms. We have positioned for this change by emphasizing small caps at the expense of large caps with our U.S. equity exposure. Small caps are traditionally domestically geared irrespective of their domicile. U.S. small caps face a potential additional benefit if the new administration follows through with promised corporate tax cuts.  Small caps would benefit disproportionately given that the effective tax rate of multinationals is already low.

 

3.  The Low Yield Environment Prevails

At its March 2017 meeting, the FOMC voted to raise the federal funds rate, the second increase since 2008’s financial crisis. However, the rise in government yields came to a halt after the FOMC talked back the future pace of hikes causing investors to scale back their expectations.

At the same time the continuing accommodative approach to monetary policy outside of the U.S. and the stronger U.S. dollar will likely lead to more foreign buying of U.S. Treasuries.  This would bid up prices and drive down yields, a headwind for the Fed.

 

4.  Monetary Policy

Historically, changes in real interest rate differentials have been the dominant driver of currency

movements in developed economies. In addition, growth in the dollar value of trade has been stronger, buoyed by higher commodity prices. Monetary policy expectations between the Fed and other G7 central banks should keep the US dollar strength in place.  A stronger dollar is both a blessing and a curse for margins. All else equal, it lowers the cost of imported goods and thereby boosts margins for import-intensive firms, while undermining profits earned overseas.

With 44% of S&P 500 revenues generated outside the U.S., the net impact of dollar strength is negative for overall corporate profits. Stronger growth is required to offset the negative impact on profits from a rising dollar.

 

With these themes in mind, we will continue to monitor economic data for traditional slow growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics.

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

 

[1] Inflation measured by Consumer Price Index (CPI) is defined as the change in the prices of a basket of goods and services that are typically purchased by specific groups of households.

[2] Capital Economics. Non-farm payrolls rise 227,000 in January and 235,000 in February.

[3] FT.com. Morgan Stanley flags ‘record gap’ between hard and soft US economic data.

[4] The Economist. Why the Fed targets 2% inflation.

[5] Kiley, Michael T. and Roberts, John M. 2017. “Monetary Policy in a Low Interest Rate World.”  Brookings Papers on Economic Activity. BPEA Conference Drafts, March 23–24, 2017.

[6] Canaccord Genuity.  Canadian Focus List. April 4, 2017.

[7] Canaccord Genuity.  Canadian Focus List. April 4, 2017.

[8] OECD Harmonized Unemployment Rates. News Release: January 2017.  Paris, 9 March 2017.

In March, we continued with our global Stagnation outlook for the twelve-month forward period. Expectations for the world economy in 2017 are relatively unchanged from last month. The U.S. economy is expected to stagnate as Trump fiscal stimulus is not expected until 2018. Political clouds on the horizon include the first round of the French election and the official start to the U.K.’s “Brexit” negotiations. Meanwhile, Trump’s “America first” approach to international relations and trade policy is an evolving challenge for the rest of the world and will be assessed on an ongoing basis for impact on the global recovery.

The Federal Reserve raised its benchmark rate to 1% (+25 basis points) on March 15th, a move that was widely expected. The Fed’s decision to hike interest rates in light of the apparent weakening in economic data since the start of the year, with the Atlanta Fed’s Q1 GDP tracker having fallen below 1% annualised, was expected. Treasuries rallied and the dollar weakened because a hawkish Fed did not turn incrementally more hawkish, and Yellen’s press conference largely stuck with the tone of her previous speech on the outlook. The committee’s confidence in the economy remains intact while recent inflationary pressure has been downplayed and the March intervention does not represent an acceleration in the normalization process. The FOMC upgraded its assessment of business investment that “appears to have firmed somewhat”.

One of the main stories from February’s employment report was the turnaround in employment growth in the three main goods-producing sectors of mining, manufacturing, and construction. When looking at the overall employment picture, inconsistencies remain (hours worked, wages, soft non-energy exports and investment intentions) and lack of clarity on U.S. tax and trade issues contributes to uncertainty. Residential investment grew to a historic peak of 7.6% of GDP, more than half of which representing renovations & transfer costs which could ease even as new construction remains elevated.

Stock market optimism has helped loosen financial conditions in the U.S. since December, even as short-term borrowing costs have advanced following the Fed rate hike. Credit spreads have fallen while the U.S. dollar has struggled to maintain its post-election ascent so far this year.  This constitutes stimulus to the global economy that offsets the tightening cycle.

U.S. equities performed strongly in February, with the S&P 500 gaining 4%, S&P Midcap 400 gaining 3% and S&P SmallCap 600 up 2%. Canadian equities posted slight gains in February, with the S&P/TSX Composite TR up 0.2%. The S&P Europe 350 TR added 2.9% and moved into positive territory for the year. After a somewhat lackluster start to the year, the S&P/ASX 200 returned 2.3% in February. Results for U.S. fixed income were positive for the month, with investment grade corporates and high yield continuing to perform better than Treasuries. Commodities performance was mixed, with Gold Spot up 3.1% and Nymex WTI Crude 0.9%.

Following the Fed’s move, we made some small changes to the portfolio models in March. In the Conservative and Moderate Growth models, we increased the allocation to U.S. Small Caps over Mid Caps. In Aggressive Growth, we shifted a portion out of U.S. Mid Caps into European Equities. In fixed income, we shifted a portion from 3-7 year Treasury and added to the U.S. Muni bond exposure in the Conservative, Moderate Growth, and Growth models. This furthers the shift to Muni Bonds that began in February.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

Deborah Frame, President and CIO
Data Source: Bloomberg

In February, we adjusted our twelve-month forward outlook to remove Inflation for the U.S. and reverted to Stagnation across all global economies. Last year, markets had to digest Britain’s vote to leave the European Union (EU) and the unexpected victory of Donald Trump in the U.S. presidential election. This year, markets will focus on three political events: first, the general election in Netherlands; second, the presidential election in France, and third, the federal election in Germany.

Investors are now coping with geopolitical and macroeconomic risks, from disintegration of the EU, a hard landing in China, to trade wars and military conflicts. The U.S. economy added 227,000 jobs in January and saw the strongest monthly employment gains since August 2016. The average number of jobless claims applications filed in January reached the lowest level since 1973, while the unemployment rate inched up to 4.8% in January (from 4.7%), as the participation rate recovered along with improving economic confidence.

Both headline and core CPI were stronger in January and producer prices have been trending up. This should not be viewed as the beginning of a new, more dangerous inflation problem, as core goods prices have been decoupling from finished goods producer prices (i.e. the last stage of production) since 2000. This speaks to the massive deflationary pressure at the end of the supply chain: a combination of deflation from imported goods, major technological advances in supply chain management, and logistics. Changing consumer behavior in an e-commerce age also means that consumers are not price takers. These factors imply that any budding inflation pressures are expected to stay trapped at the earlier stages of the supply chain and PPI will not be driving CPI prices higher.

U.S. equities kicked off the year on a positive note. In January, the S&P 500 TR gained 1.9%, the S&P Midcap 400 TR gained 1.7%, and S&P Smallcap 600 TR was down 0.4%. S&P 500 Energy TR was the worst performing sector, down by 3.6%, a reversal after last year’s rebound. It was a tough month for energy prices, with S&P GSCI Energy down 4.7% and Natural Gas Futures off 16%. While the initial OPEC agreement was announced 7 weeks ago, and Russia has been adhering to the production limits, prices are not materially increasing. Metals performed better, with copper spot and gold spot prices rising 8% and 5.5%, respectively. Safe-haven assets have been undergoing a recovery since mid-December as gold, the Japanese yen, and the Swiss franc have all appreciated.  January results for U.S. fixed income were generally positive, with investment grade corporates and high yield bonds continuing to perform better than Treasuries. The U.S. dollar index retreated by 2.7% on the back of a firmer euro (almost 60% of the DXY basket) and a stronger Canadian dollar (+3%).

Shifting back to a Stagnation outlook for the United States, we made some changes in the portfolios in February. While we maintained our exposures to U.S. mid and small caps across all models, we increased equity exposure to both Canada and Australia, and removed our neutral currency hedge to both. We lowered exposure to the 3-7 Year Treasury to fund this shift.  We also closed our position in Mortgage Backed Securities and moved that exposure into Municipal Bonds across all models.  Municipal bonds behave well in Stagnation and concern of changes to their tax advantaged status has greatly diminished.

Since November, markets have been adjusting to the surprise of a Trump Presidency and a Republican Congress.  We believe the President’s disruptive style will continue to persist in the future.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO
Data Source: Bloomberg

In January, we maintained our twelve-month forward outlook to reflect the inflationary environment that is expected to result from the new regime in the U.S. while the rest of the world continues to struggle with stagnation. While the International Monetary Fund projects that global GDP in 2017 will improve to 3.4% from 3.1%, there is currently a wide dispersion of projections given the uncertainty surrounding the policy stance of the incoming U.S. administration and its global ramifications. With price pressures building in the U.S., but not elsewhere, monetary policy divergence leading to upward pressure on the dollar will create some headwinds. The Federal Reserve is targeting three interest rate hikes next year while other global central banks remain accommodative. Powerful structural forces including an ongoing overhang of debt, adverse demographics in most major economies, ineffective monetary policy, and low financial asset returns will challenge all global economies including the United States.

U.S. fiscal stimulus will be implemented at a time when the economy is already close to full employment. At 4.7% in December, the unemployment rate is now below Fed officials’ median estimate of its natural level. The impact that technology has had in creating uneven incomes and a decline in employment opportunities will continue to be a challenge. America’s current job creation recognizes that there has been technological displacement in select industries that previously had not benefited from technological innovation. The Great Recession revealed the weakening of the link between value creation and job creation. Please see our 2016 Fourth Quarter Summary Outlook to see our additional thoughts on the impact that this global phenomenon has and will continue to have on the ability of all economies to grow.

The anticipated tightening in U.S. monetary policy commenced as December saw the Fed announce an increase in its key interest rate for just the second time in the last seven years. The S&P 500 Total Return Index surged to the finish in 2016, up 12% for the year, as investors indicated optimism with Trump’s pro-growth policies. It is notable that only about 50% of the index outperformed, with gains led by cyclical areas such as Financials, Energy, Industrials, and Materials, as these areas are expected to be direct beneficiaries of the new regime. Gains in smaller-cap equities were even stronger, as the S&P Mid-Cap 400 Total Return Index and the S&P Small-Cap 600 Total Return Index were up 20.7% and 26.6%, respectively, for the year. Global equity markets generally ended the year positively, while underperforming the U.S, in part due to the currency headwinds caused by the rising dollar. An exception was Canadian equities, with the S&P/TSX Composite Total Return Index up 21.1% for the year. The MSCI Emerging Markets Net Total Return Index ended the year up 11.2%, although the MSCI China Net Return USD Index posted a more modest 2016 return of only 0.9%. The European Central Bank continued with quantitative easing policy throughout the year and yields declined.

Following major asset allocation shifts in December, we maintained these allocations in all models in January. The models continue to reflect exposure to asset classes that provide superior expected returns in this new environment, while attempting to avoid the asset classes expected to detract from positive returns. This continues to include a high exposure to U.S. mid- and small-cap equities, and smaller exposures to Australia and Canada. Fixed Income exposure is short duration across all models.

We continue to believe reflation in the U.S. will be the key investment theme in 2017, a significant departure from the post-2008 period when dovish monetary policy kept interest rates on a downward spiral. We do not expect the new regime to carry out all the extreme protectionist threats that were at the center of the election campaign. In addition, with commodity prices likely to recover, aggregate growth in emerging economies will continue to accelerate, although China’s economy will likely continue to slow.

We will continue to monitor the data for growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO
Data Source: Bloomberg