October – Positive economic data sets stage for 2018

Market Views And Insights | November 20, 2017

Global economic data continues to impress: US consumer confidence and German business sentiment have hit new highs. China’s economy has stabilized, and after the successful 19th Party Congress and diplomatic visit by US President Donald Trump, the country is focusing on upgrading the economy.

The positive economic data sets the stage for 2018. In this edition of Monthly Macro View, Geoff Lewis provides insight on the factors underpinning global synchronized growth, and why the global portfolio is overweight equities and underweight bonds going into 2018.

Review of markets in October

Markets were in "risk-on" mode in October, supported by politics (North Korea fading from the headlines, Mr Abe's landslide victory in Japan), progress on US tax reform, positive economic data and a good start to the third quarter earnings season.

Equity market performance highlights 1


  • The MSCI AC World equity index rose 2.10%.
  • The US gained 2.3%, while Europe gained 0.5%
  • Japan gained an impressive 4.6%, as investors welcomed Mr Abe's third term as Prime Minister as a sign of political stability
  • Among Developed Markets (DM), Canada registered a slight negative return due to weakness in the Canadian dollar.
  • Emerging Markets (EM) outperformed with a 3.5% gain, although within EM Latin America fell 3.6% while Asia gained 4.1%.
  • By global sector, IT was the star performer last month on strong results, (+7.2%) followed by Materials (+3.1%)
  • Health Care (-1.3%) and Telecom (-2.9%) posting negative returns.


Fixed income performance highlights 2


  • Global aggregate and government bond indices showed negative returns in October, mostly a reflection of US dollar strength, and a rise in the 10-year US Treasury yield over the month by 5 basis points (bps). Other DM bond yields did not follow suit.
  • High Yield and EM USD both registered a positive return of 0.4%. In foreign exchange markets, the main feature of October was dollar strength, with the DXY trade-weighted index appreciating by 1.6% (See Figure 1).
  • Strength was broad-based – among the majors, the euro lost 1.5% against the dollar, the UK pound 1.0%, the yen 0.9%, while the Canadian dollar, beset by NAFTA fears, fell 3.0%.


The dollar is expected to see some further gains ahead of a December Fed rate hike and tax reform hopes, even though a hike is 85% “priced in” by markets. There was nothing in the November FOMC statement to make us think that the Fed will pass on a December rate hike.

Reflecting the strong global economy, October was a good month for commodities. The S&P GS commodity basket rose 3.8% in US dollars, with strong price gains in copper, aluminum and oil. With the synchronised global upturn expected to continue in 2018, the outlook for the commodity space is constructive.

Figure 1: US dollar trade-weighted index rose in October as short positions unwound 3


Economic data continues to impress

US market shows high consumer confidence and strong GDP growth 4

Recent US activity data has been better than expected. This includes many of the "hard" data releases. As a result, the US activity surprise index is in an uptrend. Damage to the US economy from the recent hurricanes, though a hard blow for families directly affected, was less of a negative shock at the macro level. Consumer confidence, for example, is close to a 17-year high5. The buoyant labour market and prospect of tax cuts next year should support consumer demand in the near term, though we have some reservations over the sustainability of the trend in view of the low household savings rate.

US GDP growth in the third quarter beat expectations at 3.0% (seasonally adjusted annual rate), with trade and inventories together contributing over 1.0% to growth. Private domestic demand (GDP net of trade, inventories and government spending) - a more stable measure of the underlying trend in activity – expanded at a slower 2.2% rate in the third quarter. Despite the fall in the unemployment rate, there is no indication of wages gains accelerating – the 12-month trend increase in average wages at 2.6% is similar to a year ago6.

Figure 2: Global economic data continues to surprise to the upside 7


Eurozone strong with German business sentiment at all-time highs 8

In the eurozone, GDP growth rose to 2.5% year-on-year, beating expectations and the fastest pace since 2011. Germany's IFO business climate index in October rose to an all-time high9, led by the future expectations component. Capacity utilisation in Germany is at a high level and the latest European Central Bank survey of bank lending points encouragingly to stronger loan demand for investment purposes. Despite stronger activity in Europe, there are currently few signs of inflation pressures. The opposite is the case as in October core inflation (excluding food and energy prices) unexpectedly dipped below 1.0% year on year, with headline inflation also easing to 1.4%.

Figure 3: IFO survey points to a strong German labour market 10


Mixed results in China with continued growth momentum but weaker PMIs 11

In China recent economic data has been more mixed. The official manufacturing and services Purchasing Manager Indexes (PMI) both eased back in October, though the SME and export-oriented Caixin manufacturing PMI held up better. Weakness in the official PMIs occurred mainly in the polluting heavy industries affected by winter production controls. With business confidence high and demand and price indicators holding up, we feel growth momentum is unlikely to fall sharply in the fourth quarter. While the Chinese property sector is expected to weaken and act as a drag on growth, the new policy initiatives unveiled at the party congress last month should be sufficient to support growth of 6% plus in 2018.

Figure 4: World business confidence is a record high 12


For the export-oriented economies of Asia, the good news is that world trade volumes are once more growing faster than industrial production. As Figure 5 shows, the world economy has come a long way since the 2008-09 recession. The recent narrowing of the gap between the two lines signals improving trade performance.

Figure 5: World output & trade in levels 12


Outlook for 2018

While the macro data has clearly been positive, it remains our view that buoyant survey readings are probably running “rich” relative to reality. Nevertheless, outside of Europe, economists have been slow to revise up their 2018 GDP forecasts and there may still be some upside risk to forecasts.

Many investors will know that a good macro outlook for 2018 need not necessarily mean strong market returns as in 2017, though a favourable economic backdrop certainly helps. 2017 was a year characterised by positive growth surprises and negative inflation surprises, a combination that helped to boost financial asset returns. 2018 is likely to be a more neutral year in this respect, since expectations will be starting from more elevated levels.

Thus, average returns in 2018 are likely to be lower than in 2017 and volatility somewhat higher. Headline consumer price index (CPI) inflation, for example, could see some upward pressure in 2018 if the oil price were to strengthen further, moving into a US$60 to US$70 range. Central banks would most likely “look through” any oil-related increase in CPI, though it could trigger nervousness among investors.

We think equity valuations are unlikely to mean revert unless bond yields rise sharply. But with global inflation subdued and monetary accommodation being withdrawn only gradually, yields are expected to remain well behaved in 2018. Our global portfolios remain overweight equities and underweight bonds. Within equities we prefer the US, Japan and Asia over Europe, the UK and EM outside Asia. Within fixed income, we are quite cautious in the short term after the recent sell off in High Yield and appreciation of the trade-weighted dollar. But we expect that the quest for yield will still be there as a theme for fixed income investors in 2018.

US Tax Reform

There appears to be a reasonable chance of some kind of US tax reform package being approved by Congress. There are significant differences between the House and Senate tax bills and tough negotiations lie ahead. Agreement on a reconciliation bill is likely to be delayed until the first quarter of 2018. The basic features have not changed much from President Trump's original plan, if one excludes dropping the unworkable Border Adjustment Tax. For companies, if the corporate tax rate falls from 35% to 20%, firms will be able to fully expense new investment. For large firms, interest payments will only be partially deductible. Personal tax brackets are reduced from seven to four – 12%, 25%, 35% and 39.6%. Keeping the top marginal rate unchanged at 39.6% helps to appease those critics who object to giving tax cuts to the rich.

October's fiscal year 2018 Budget Resolution allows for total tax cuts of US$1.5 trillion over 2018 to 2027. So Republican tax reform is not being done based on revenue neutrality, which was never a realistic option. The budget deficit will increase significantly over the next 10 years. But by less than the US$1.5 trillion, as there should be some positive effects from the tax measures on economic activity (what policy analysts refer to as "dynamic scoring").

Congress agreement on tax reform could give a strong boost to stocks and business confidence

As it stands, the package is more concerned with tax reform than fiscal stimulus, though the net tax reduction is worth about 1% of GDP for the first three years, and would be the third largest US tax cut ever. Economists tend to attach fairly low GDP multipliers to tax cuts. The consensus GDP growth forecast for 2018 (2.4%) barely changed in October, as forecasters will already have made some allowance for tax cuts in their projections.

All that said, to focus on the macro or GDP impact of the US tax package is to largely miss the point, however. It is the microeconomic effects that matter most. The majority of US firms stand to benefit from lower corporate tax rates. Banks are one of the highest tax-paying industries in the US and the sector stands to benefit significantly. A second potential benefit for many firms is the current expensing of investment spending. This is likely to trigger an increase in investment in capital projects and hence loan growth and demand, which will also be beneficial to banks. Other sectors with high effective tax rates include consumer staples, consumer discretionary, utilities and industrials.

To sum up, there is still considerable uncertainty as to whether Congress can agree on tax reform in the first quarter of 2018 and as such it is not priced into markets. But if it does go ahead, the tax reform would give a strong boost not just to the S&P500 (potentially a 7% addition to EPS in 2018)13, but to business confidence and stock markets globally.

Changes of the Fed Chair and its impact

President Trump announced that Fed Governor Jerome Powell will become the new Chairman of the Federal Reserve (Fed) when Janet Yellen retires in February. A lawyer by training, Mr Powell's record since joining the Fed in 2012 shows him to be a relatively dovish team player who has tended to vote with the majority at Federal Open Market Committee (FOMC) meetings. Seen as a vote for continuity, the announcement was a non-event for markets. Powell is not expected to make any immediate changes to the Fed's current policy trajectory of gradually raising interest rates whilst reducing the size of the balance sheet. Like Randolph Quarles, Powell is regarded as favouring a “lighter” regulation touch than Janet Yellen. Although he thinks capital and liquidity ratios are broadly appropriate, he favours simplifying the Dodd-Frank legislation where possible to reduce the regulatory burden on banks. His appointment can be regarded as positive for US financial stocks.

Mr Powell would also seem to be a good choice for Asia and the emerging markets. His speeches show that he adheres to the Yellen doctrine that in setting policy, the Fed should be mindful of potential spillovers to other economies. Recall that in September 2015, the Fed was widely expected to raise rates, but Yellen held back, citing volatility in China’s markets among her list of reasons. In today's closely integrated global economic and financial system, a somewhat broader policy perspective than the traditional domestic inflation focus of central banks makes sense.

The FOMC will see many changes next year. Janet Yellen is expected to retire once her term as Chairman ends in February 2018; New York Fed President Bill Dudley has said he wishes to retire in 2018 while two FOMC seats remain unfilled. The important point is that with the central bank at the epicentre of the international fiat monetary system, the Fed's credibility must not be compromised. In this respect, President Trump's first two Fed appointments have been sound.

Trump Visit and China after the Communist Party Congress (CPC)

President Trump's Visit to China "a resounding success" 14

China was the most important stop on President Trump's Asian tour and must be judged a resounding success. China and the US signed trade deals totalling US$253 billion (for comparison, the entire 2016 bilateral trade deficit with China was US$253 billion15), covering everything from agriculture and auto parts to energy. As the deals are mostly with large Chinese SOEs, Beijing can ensure that there is good follow through e.g. a large Chinese energy SOE signed a US$43 billion joint venture to explore for natural gas in Alaska, creating 12,000 jobs.

Trade deals immediately followed by the liberalisation of China's financial sector ought to take a lot of the heat out of US-China trade relations. The success of President Trump's visit to Beijing provides a welcome breathing space, during which the negotiating teams can hopefully make progress on more difficult issues, like IP copyright, technology transfer etc. It will help to restore trust and maintain good trade and investment ties between the US and China. It is confirmation that the world's most important economic relationship cannot be allowed to deteriorate without damage to both sides. A potential risk is that the monthly US/China trade deficits are slow to fall, which is possible since many of the deals are long term in nature. That might test the patience of President Trump, who is very much focused on getting the US trade deficit to improve.

On 10 November 2017, the day after President Trump's visit, Vice Finance Minister Zhu Guangyao announced a major financial reform – the opening up of China's domestic financial markets to foreign banks, brokerage houses and insurance companies16. This is a very positive step that may seem bold, but which in reality is long overdue. Domestic financial leaders in China are strong and markets highly competitive. Foreign financial institutions may find themselves initially restricted to niche business areas, though in the long run the opportunities could be great.

China becoming more active in world affairs

At the 19th Party Congress in Beijing in mid-October, President Xi Jinping consolidated his grip on power, becoming only the third leader after Mao and Deng to have his political "Thought" enshrined in the Chinese Constitution.17 From his opening speech, it is clear that under Xi China intends to play a far more active role in world affairs. This could have benefits for the west through gaining China's cooperation and participation in key global issues. But it is also likely to pose challenges if China's own interests are to be accommodated.

Liu He, President Xi's top economic aide and regarded as pro-reform, was reappointed to the central policy committee. But we do not expect to see a major shift towards more liberal, market-oriented economic policies in 2018. Xi has shown little appetite for privatisation. He clearly prefers the party to retain a strong role, not just in the economy but in most areas of Chinese society. How successful this will prove in the long run, as China's economy and society become more sophisticated, is open to question. But for now, it remains a viable policy choice.

Key themes for investing in China going forward

We expect to see further efforts to improve the performance of China's state owned enterprises (SOE). This will include a greater role for public-private partnership (PPP). The idea is that SOE managers can learn from China's successful private sector entrepreneurs. The risk is that PPP becomes a source of funding for loss-making SOEs, while increasing the influence of central government over private sector companies. Key economic themes for the next few years besides SOE reform include cleaning up the environment (“Beautiful China”), reducing excess capacity in heavy industry (Supply Side Reform), and financial de-leveraging (Macro Prudential Framework). There will be more focus on the sustainability and quality of growth, with a strong commitment to eradicating poverty and reducing income inequality.

China’s "New Economy" and related opportunities

President Xi also announced at the CPC that China should become a world leader in innovation by 2035. China's "New Economy" - IT, the internet of things, electric vehicles, green energy etc – can expect to receive strong support from the government to achieve this aim. Beijing regards new industries like electric vehicles as a chance to ”leapfrog” as opposed to merely "catch up" with western technology. R&D spending is growing rapidly in China, as is tertiary education in science, mathematics, computing and technology.

China already possesses the world's most advanced e-commerce ecosystem. A giant e-commerce platform operator, for example, claims that 549 million people use its smartphone shopping apps every month.18 On 11 November, This giant e-commerce platform operators "Singles Day" promotion smashed all records, with online transactions of US$24 billion, up more than 30% from last year. To give another example, a ride-hailing service has set up a joint venture to build a charging network for electric vehicles (EV) right across China. The company also plans to expand its fleet of EVs from 260,000 to one million by 2020.19 As the acceleration of the "New China" economy should provide be many good opportunities for foreign investors to participate in.

Figure 7: China companies to spend more on R&D 20


Figure 8: China consumers prefer e-commerce 21

1 Factset, as of 31 October. MSCI indices’ total returns in US dollars.
2 Factset, as of 31 October. Barclays' bond indices’ return in US dollars.
3 Bloomberg, Manulife Asset Management, November 2017.
4 US Department of Commerce, Reuters, 27 October 2017.
5 Conference Board, 31 October 2017.
6 Bureau of Labor Statistics, US Department of Labor, 31 October 2017.
7 Citi Economic Surprise Index, Citi Research, Bloomberg and Manulife Asset Management calculations, 1 January 2015 to 7 November 2017.
8 Eurostat, 31 October 2017.
9 The CESifo Group, as of October 2017.
10 HSBC Global Research, November 2017.
11 National Bureau of Statistics of China, 31 October 2017. Markit Economics, 1 November 2017.
12 Datastream, November 2017.
13 "Key Macro Themes," D Rissmiller, www.stratgasrp.com, 8 November 2017.
14 South China Morning Post, 9 November 2017.
15 Research Report on China-US Economic and Trade Relations, Ministry of Commerce of the People’s Republic of China, 25 May 2017.
16 Reuters, 10 November 2017.
17 See 'China's 19th Communist Party Congress – Onward and upward!' Manulife Asset Management, 7 November 2017.
18 See South China Morning Post, 3 November 2017.
19 See Sunday Morning Post, 12 November, 2017.
20 HSBC Global Research, November 2017.
21 CLSA Research, October 2017.

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