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Market View

Lord Abbett experts discuss the global economic outlook for the coming year and offer their perspective on potential investment opportunities.

 

In Brief

  • What are the global macroeconomic factors that could influence investment decisions in 2018? We asked Lord Abbett investment professionals for their views.
  • Giulio Martini, partner and director of strategic asset allocation, says that with inflation subdued and no end to the global economic expansion in sight, risks overall may be skewed to the positive side of the return distribution and that equities and corporate credit should continue outperforming risk-free bonds.
  • Central banks are more deserving of accolades than opprobrium for their success in stemming the global financial crisis of 2008–09, according to Martini.  
  • Martini notes that an environment that couples strong growth with few surprises (such as in monetary policy) is ideal for investors.
  • Leah Traub, partner and portfolio manager, believes that emerging markets are poised to benefit from continued global economic growth in 2018 as domestic demand picks up.
  • The U.S. dollar is likely to continue its position of weakness against the currencies of its major trading partners, according to Traub.
  • Dollar weakness may change the dynamics in favor of local currency-denominated bonds in 2018, says Traub, as the monetary policies of most central banks remain accommodative.

 

Global Macroeconomic Outlook
A powerful global earnings recovery that began in mid-2016 picked up momentum throughout 2017, and is closing the year on a high note. The recovery had many mothers, according to Giulio Martini, partner and director of strategic asset allocation, including improving trade flows, rising capital spending, accommodative financial conditions, and the retreat of key structural risks that long had troubled investors. For example, stability in China during the run-up to the 19th congress of the Communist Party of China, in October, assuaged fears centering on rapid debt growth. Elsewhere, the electoral victories by mainstream candidates in France and Germany quelled worries that angry populism would lead to an unstable policy framework. In the United States, as 2017 drew to a close, the prospects for corporate tax reform brightened, and analysts’ expectations for potential earnings increases from lower tax rates were added to increases already stemming from rising organic revenues.

Inflation remained subdued in 2017 in the economies of developed countries, despite, as Martini observed, the acceleration in global economic growth. Labor costs also rose at a very restrained pace, even in countries such as the United States, where the U-3 unemployment rate (the most commonly cited measure by the Bureau of Labor) fell below levels that historically had triggered more rapid acceleration in wages during previous expansionary periods. Persistently low inflation allowed key central banks—such as the U.S. Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ)—to either maintain highly simulative policies or to withdraw accommodation very gradually. As monetary policy remained highly predictable, despite the positive growth surprise, the volatility of asset returns, both empirical and implied, fell to very low levels.

An Ideal Environment?
For global investors, an environment that couples strong growth with few surprises is ideal, according to Martini. In the United States, Martini believes that so long as “core” inflation—i.e., headline inflation excluding food and energy prices—remains subdued and labor costs accelerate only moderately, stocks and corporate credit should continue outperforming risk-free bonds. “Of course, with a lower equity-risk premium following two years of very strong stock returns and compressed credit spreads, returns in 2018 should be relatively low,” Martini said. However, with no end to the global economic expansion in sight and a promising economic environment in the United States, China, and the eurozone in 2018, Martini believes that risks overall are skewed to the positive side of the expected return distribution for equities and credit, both within the United States and abroad.

Kudos to the Central Banks
Since the financial crisis of 2008–09, investors have been worried that the extraordinary actions taken by central banks—such as cutting short-term interest rates to zero and, in some cases, below, expanding balance sheets aggressively—would inevitably lead to sharply higher inflation and asset price bubbles. Contrary to those expectations, however, inflation has remained very low, and there is only limited evidence of worrisome asset price bubbles, according to Martini. “While the 1,100%-plus rise in the prices of the digital currency bitcoin in 2017 has all the characteristics of a classic speculative mania, it remains an isolated case, and thus doesn’t threaten to radiate out more broadly into the financial system or real economy if bitcoin prices should suddenly collapse,” Martini said. Indeed, with real household net worth at an all-time high, corporate profits healthy, and financial leverage sharply reduced compared with the setting prior to the last downturn, Martini believes that the U.S. economy would likely be much more resilient than usual if there occurred a sudden drop in asset prices. Thus, according to Martini, “central banks may be more deserving of accolades for the aggressive actions they took to stem the financial global financial crisis and the threat of a euro currency meltdown in 2010–12, than the opprobrium they have received from analysts who forecast that their actions would inevitably be followed by even greater pain.”

Emerging Markets May Benefit
Given the expectation that global growth will continue to increase in 2018 (with the exception of some slowdown in China), Leah G. Traub, partner and portfolio manager, believes emerging markets (EMs) are positioned to reap the benefits, especially those export-oriented economies in Asia and Central and Eastern Europe.

Traub believes that commodity prices should remain supportive, but that we probably will not see a repeat of the price increases we saw in 2016 and 2017. “The improvement in the external balances of commodity producers has likely peaked,” Traub says, “and 2018 should see a gradual worsening in those trade balances.” However, many EM countries were forced to implement structural reforms following the so-called “taper tantrum” in mid-2013 (when investors drove up U.S. Treasury yields rapidly on fears that the Fed’s balance sheet would quickly be reduced and that short-term rates would be increased) and then the collapse in commodity prices that began in 2014. As a whole, Traub believes, the EM countries now are less dependent upon foreign inflows and better able to handle external shocks than they were four years ago.

Elsewhere, domestic demand has been depressed in many Latin American and Asian economies. As that continues to recover, growth should pick up. “The growth differential between the emerging and developed markets began widening this year, and should continue to do so in 2018. That should drive better currency and local bond market performance relative to the United States,” Traub observed.

Continued Weakness for U.S. Dollar
The U.S. dollar was weaker in 2017 than many observers had expected. Despite two Fed interest-rate hikes, with another one likely in December, and most other major central banks still in easing mode, the dollar (as measured by the Federal Reserve Board’s Trade Weighted U.S. Dollar Index) weakened, by nearly 7%, against the currencies of a broad group of major U.S. trading partners. It is difficult to see this trend reversing in the beginning of 2018, said Traub, since the factors driving the dollar’s relative weakness are still present.

First, the U.S. yield curve has been flattening, both in absolute terms and relative to European and Japanese yield curves. This flattening normally occurs during periods when the Fed is hiking short-term interest rates, causing the short end to rise more than the long end of the yield curve. Over the past year, this has gone to an extreme, as the 10-year and 30-year yields have fallen, while the two-year and five-year yields have been rising. This means that the market thinks the Fed’s hiking cycle will be gradual, shallow, but still ahead of where inflation is. Historically, when the yield curve flattens during a hiking cycle, the dollar weakens against most other currencies.

This leads to the second reason behind the softness in the dollar: weaker than expected inflation. Core inflation has fallen throughout the year due to a number of factors. While some of these factors are cyclical in nature, such as increased competition in the wireless phone industry driving price declines, the surprising driver has been the absence of any significant wage growth, despite a low and still declining unemployment rate. Without a meaningful increase in inflation, it is hard to see interest rates rising rapidly, capping any dollar appreciation.

Finally, as Traub observed, growth in Europe and parts of Asia has been outpacing U.S. growth this year. Rising global growth has led to a rise in global trade, which in turn benefits countries that are more export-dependent than, say, the United States, which is a net importer. Flows have increased into export-driven countries, both into the real economy in the form of trade and foreign direct investment, and into the financial markets, causing their currencies to rise at the expense of the dollar.

EMs and Central Bank Policies
“What makes this Fed rate-hiking cycle different from those of the past is that most of the rest of the world is not hiking alongside it,” Traub said. “On the contrary, the ECB, BoJ, and the Bank of England are still engaging in quantitative easing, and are expected to continue buying some amount of bonds through most of 2018.” (The Bank of England’s program likely will end in the first quarter of 2018.) While this easing may taper off over the course of the year, rate hikes by the ECB or BoJ are not in the cards until 2019, Traub believes. In addition, several EM countries will continue to cut interest rates and even more EMs are anticipated to be on hold.

This difference will be very supportive for other countries’ government bond markets, Traub observed. Inflows into EM local currency bonds turned slightly positive in 2017, but were dwarfed by the large flows into EM bonds denominated in U.S. dollars. In 2018, Traub believes that the dynamics should change in favor of local currency-denominated bonds, as the yield differential is attractive, and there is the possibility for price gains as those central banks remain accommodative and the dollar continues to soften. 

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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