The completion of the financial year is as good a time as any to take stock, stand back and assess “the big picture”. With the daily news cycle filled with Trump’s tweets, North Korean ICBMs, refugees pouring out of North Africa and the Middle East into Europe, and terrorist attacks seemingly a weekly occurrence, it is easy to become disconsolate. Noted global strategist George Friedman made the following point recently: “Many believe there have never been more contentious times than those in which we now live. It’s a belief shared by most everyone of every era. I admit that times are strange, and in some ways they are unlike any other. But are they as bad as the late 1960s and early 1970s, the decade of assassinations and riots, of slain war protesters and Richard Nixon? Are they as bad as McCarthyism or the Great Depression or the Civil War?”
While many of us do feel a distinct dislocation in the global polity, the authors of this article think the answer to Friedman’s question is “No, the present time is not as bad as many earlier periods of global uncertainty – periods with which we have coped and overcome”. In this piece we will consider some of the key investment markets overseas and in Australia, and attempt to place the opportunities – and the risks – in an appropriate context. Today’s View is part 1 of a two-part series where the second part will be published this Friday 7 July. Today we cover global matters; the Friday report will focus on Australia.
Global share markets have had a good run over the past 12 months

Figure 1. Major indices total return (rebased)
Source: Clime Research

The global economy is recovering from the GFC

The broad-based pick-up in the global economy since the dark days of the GFC is continuing. While above-trend growth is still absent from most advanced economies, there are positive signs emerging. Generally, forecasts for global growth have been revised up from last year. Labour markets have tightened in many countries especially in the US and the Eurozone; consumer and business confidence in both those zones have also increased significantly. In China, growth is being supported by increased spending on infrastructure and property construction, and the consequent rise in commodity prices over the past year has boosted Australia’s national income.
Headline inflation rates, while having moved higher over the past year, do not pose too much of a problem, and have been assisted by lower oil prices. Wage growth remains subdued in most countries, as does core inflation. As we have written about many times over past months, further increases in US interest rates are expected by markets and there is no longer an expectation of additional monetary easing in other major economies: the emergency measures designed to counter the GFC are slowly being unwound. Financial markets have been functioning effectively and volatility has been low.

Reduction in perceived global risk

The Global Economic Policy Uncertainty Index (GEPU) measures 18 of the largest economies and has as the base measure of the Index a score of 100. The chart below shows the Index peaking at 300 last year, and the subsequent reduction in global economic uncertainty to below 200 today. Clearly, the trend shows uncertainty diminishing. This is probably also reflected in the unusually low levels of equity market volatility represented by the VIX index (or “fear index”) covered in previous editions of The View. As the chief economist of the OECD has stated, things are “better, but not good enough”. The OECD expects a modest pick-up in global growth this year and next. The hope is that this will be the beginning of a sustained upswing, in which strengthening investment and faster productivity growth keep inflation in check.

Figure 2. Global Economic Policy Uncertainty Index (PPP Adj GDP Wts)
Source: Strategas,

Global earnings growth

Equity markets usually require a conducive macro-economic environment in which to thrive, but ultimately fundamental value must be supported by company earnings. Earnings growth is clearly evident in the US, as shown below…

Figure 3. S&P 500 Trailing 12 Month Y/Y Earnings Growth
Source: Strategas, Bloomberg
It is also evidently recovering in Europe. The Stoxx 600 is an index of 600 large cap listed European companies covering 18 European countries and approximately 90% of total European stock market capitalisation.

Figure 4. Stoxx 600 Trailing 12 Month Y/Y Earnings Growth
Source: Strategas, Bloomberg
And even in Japan. Of course, the question remains whether or not these patterns of earnings recovery can be maintained.

Figure 5. Nikkei 225 Trailing 12 Month Y/Y Earnings Growth
Source: Strategas, Bloomberg

The Macron factor

A mere three months ago, market pundits were calculating the chances of a Marine Le Pen victory in the French presidential election, and the risk of “Frexit”. Today, Emmanuel Macron has secured an unprecedented victory, with his newly-minted centrist political party En Marche! (founded just 18 months ago, and bearing Macron’s initials). He now dominates the National Assembly with 54% of members, and has a progressive reformist and market-friendly agenda. The mood in Europe has shifted and a new sense of optimism is in the air.

The officially released portrait of President Emmanuel Macron of France, which will hang in every town hall, post office and police station in France, and in every French embassy.
Eurozone “animal spirits” are stirring – see rising business confidence…

Figure 6. Eurozone Business Confidence (SA, %Bal/Diffusion Index)
Source: Strategas
And so is consumer confidence on the ascent.

Figure 7. Eurozone Consumer Confidence (SA, %Bal/Diffusion Index)
Source: Strategas

USA recovery continues

US real GDP growth is far from “robust” – but on the other hand, there are significant positive signs that suggest the recovery remains on track, particularly in employment, housing, manufacturing and energy markets. Growth is still far off the rate promised by President Trump, but could be boosted if just some of his tax and business-aligned policies gain traction.

Figure 8. Real GDP (% Change – Annual Rate; SAAR, Bil.Chn.2009$)
Source. Bureau of Economic Analysis /Haver Analytics


China’s Purchasing Managers Index (PMI) suggests a soft landing is the most probable scenario. This is true for both the manufacturing sector, and the services sector.

Figure 9. China: PMI: Manufacturing (SA, 50+=Expansion)
Source. China Federation of Logistics & purchasing /Haver Analytics
China’s non-manufacturing sector continues to expand from the lows of 18 months ago, in line with Xi Jinping’s policy of strengthening domestic consumption.

Figure 10. China: PMI: Nonmanufacturing Business Activity (SA, 50+=Expansion)
Source. China Federation of Logistics & purchasing /Haver Analytics
So much for the good news – but what about the risks?
Central banks have kept monetary policy extraordinarily loose for the last 10 years – arguably a necessary response to the GFC. But while these policies helped stabilise financial markets and economies, they have created significant risks. As central banks prepare to retreat from Quantitative Easing, the money-printing programs that have seen trillions of dollars pumped into world markets since 2008, and look at hiking rather than cutting interest rates, asset prices could be vulnerable. Over “the long term”, asset prices will be driven by fundamentals. Highly correlated positive returns have been the order of the day, beneficiaries of the flood of liquidity – across all asset classes, including shares, property, and bonds. No doubt, many investors are far too complacent.
As the central bankers exit the stage over the next couple of years, will we return to the pre-GFC days? In truth, no one really knows. No doubt, change will be a constant with demographic, technological, geopolitical and climate challenges ahead. More immediately, however, markets face the following serious issues:

The end of ultra-loose monetary policy

The Federal Reserve, along with other central banks, lowered short-term rates to near-zero levels during the GFC. With the economy on the mend, and asset prices like shares and property soaring, Fed officials have begun raising short-term rates and intend to continue to do so. Markets are pricing in around four or five rate hikes over the next few years, from 1.25% today to 2.0% in 2018 and around 3% in 2019, yet leaving real rates in negative territory. An obvious risk is that monetary tightening will be too fast. However this flies in the face of repeated communications stressing that the Fed is far more concerned with being premature in pulling back the reins, rather than erring on the side of facilitating excessive economic momentum.

The rise in bond yields

Probably a greater risk than the increase in official cash rates lies in the behaviour of bond markets. We anticipate an increase in global bond yields, albeit not to pre-GFC levels. Global bond markets probably do not currently reflect this view, however, and significant value erosion may be ahead. The US Fed plans to shrink its balance sheet as it retreats from QE; this should put longer-term bond prices under pressure, as yield curves steepen. Long-dated sovereign yields can be expected to rise globally, albeit from extremely low levels compared to the onset of a traditional hiking cycle. The biggest repricing should come from Europe where QE remains in place. As most investments are in effect priced against the so-called “risk-free” rate, it is possible that a rise in government bond yields might trigger a widespread decline in asset prices.

Bond yields tick up in Germany

See below significant move upwards in German bond yields – across the yield curve (reflected in the 5 year and 2 year bunds, both of which have broken through long term trend lines), indicating further rises to come.

Figure 11. German 5 & 2-year Yield (50 & 200 Day MA)
Source. Strategas
Inflation is not a problem (except for asset prices)
Almost everywhere in the world (forget about Venezuela and Zimbabwe), inflationary pressures remain remarkably subdued. Despite years of pundits forecasting that excessively loose monetary policy would create massive inflation – they have been dead wrong. Consumer and producer prices have hardly moved for years; all the inflationary pressures have been concentrated in asset prices. Thus a resurgence of inflation is not a large risk. This is because of globalisation, which has greatly enhanced competitive pressures, demography (the ageing of the baby boomers) and technology (mobile phones and cloud computing, amongst many others).
In the key US market, inflation is “not too hot, not too cold”, providing Janet Yellen and the Fed with the receptive environment in which to “normalise” cash rates at a very slow pace. As a measure of slack in the economy, US capacity utilization is a good indicator of inflation pressures. US capacity utilisation was 76% in May, and although trending higher, utilisation typically approaches 85% before an inflation problem develops, usually leading inflation by 12 months.

Figure 12. PCE: Chain Price Index
Source. Bureau of Economic Analysis /Haver Analytics
Global debt levels are elevated
Globally, debt is at record levels: in 2007, the stock of non-financial sector debt in the advanced economies stood at around 180% of GDP. In 2016, this has risen to around 220% of GDP. Particularly noteworthy, and concerning, is the remarkably rapid growth of credit and debt in China.
As interest rates rise, financial risks will crystallise. Yet reasons for optimism on this point also exist: the financial system is better regulated and capitalised than it was in 2007; the Chinese authorities can stabilise their financial system, if necessary; no globally significant credit-driven boom appears evident, except in China; and even though prices of expensive equities might fall, there is little reason to believe such fall would be long lasting. So long as inflation remains subdued, both monetary and fiscal policy responses remain available – certainly in the short term.
Indeed, equities could perform much better than many expect as QE is unwound. For the time being at least, the likely improvement in global economic fundamentals should outweigh the impact of higher interest rates. The problem is that current valuations are already elevated. But that discussion will have to hold over for another day.