The first message is that global economic news has been positive over the summer months. Across the major economies, recent data has pointed to growth being solid and inflation low or well behaved. The International Monetary Fund provided a positive tone in early July when their update of the state of the world economy reiterated the positive message they had previously made in April. They foresaw a solid pace to global growth this year and next and a strong recovery in global trade. This latter point is particularly important, as in recent years there has been a downbeat view among economists about the prospects for global trade. There has also been good news across many regions.
Earlier this year, the market became upbeat about the US, and even though expectations were then scaled back for a while, more recently monthly economic statistics in the US have surprised on the upside.
It has, however, been the euro area where financial markets have been most caught most unawares by positive economic news. We have been outlining that there would be a cyclical recovery in the euro area - largely thanks to the generosity of the European Central Bank. Their policy of low rates and quantitative easing has provided a huge stimulus. As a result, the euro area has strengthened, and the market appears to be now appreciating that this recovery can continue. In turn, the euro has been strong, particularly against sterling, but also against the dollar.
It is not only western economies, but also China and emerging economies, where the news on growth has been positive, contributing to a rise in the price of base metals, especially zinc and iron ore. Despite this, oil prices remain low, keeping global inflation expectations under control. The strength of emerging markets has a number of implications. One is the longer-term impact for our portfolios - as we are positive about their future growth. Another is the impact they have now on the global economy.
The positive view of the world economy that we have outlined before has been justified by the data. Also, it is worth repeating that the growth in nominal GDP - which is growth plus inflation - combined with low interest rates and yields, could contribute to favourable budget deficit news in coming months. Indeed, the latest monthly figure in the UK showed a welcome lift in government tax revenues.
Second, this macro-economic backdrop has been constructive for financial assets. Bond yields have been low and equity markets have performed well. Asset valuations are high and volatility is low. While this macro-backdrop has created favourable conditions for financial markets, some caution is required. As I have stressed before, the combination of high valuations and low rates means financial markets may not be pricing fully for risk and thus they are vulnerable to shocks or even to abrupt changes in sentiment.
One economic worry for markets would be if inflation shocked on the upside. Another issue is, of course, how economic growth and financial markets would respond to a more widespread phase of monetary policy normalisation - with rates rising and quantitative easing being reversed. Yet, it would only be in the event of bad inflation news that policy might be tightened aggressively across major economies. Although this is not our - or the market’s view - it should be said that the markets have failed to predict the strong or improving labour markets that have been seen across many economies. And, continuing this theme, it is always possible that wage growth could, in turn, grow more strongly than is generally expected. If so, this could be the factor that triggers more aggressive monetary policy tightening too.
One of the many issues we always take in account is capital flows, as it is always important to see where money is heading. Investors clearly are looking for a home for their money, to benefit from the current favourable global economy. While subject to frequent revision, data on capital flows from the Washington-based Institute for International Finance suggests a number of interesting trends. One is that there were large capital outflows from China during the first half of this year, totalling $21bn in Q1 and $80bn in Q2. While this might be positive for western economies, it also raises questions about whether investors are worried about the sustainability of current growth in China, or whether they are more cautious about the Chinese currency. If this weakens, it would add to competitive pressures across Asia and, in turn, across other economies too. Also, Brazil saw its first net capital outflows since the end of 2008. Despite this, there were strong capital inflows into other emerging markets, and excluding China, these inflows totalled $19bn in Q1, $35bn in Q2 and $20bn in July. Clearly there are risks, but many opportunities too. The important message, always, for investors is to take a longer-term approach.
Third, here in the UK, there has been much good economic data, although the best way to describe the picture is mixed. The economy slowed in the first half of the year compared to the end of 2016. Despite this, there has been much good economic news in the UK over the summer. The most positive development has been that for two successive months, inflation has been lower than feared. While it is premature to suggest that UK inflation has peaked, recent data suggests the peak in inflation could be sooner, and lower than previously expected. If so, this eases the pressure on the Bank of England to tighten. Just as importantly, if inflation peaks this autumn, and then decelerates, then this will provide a boost to real income and consumption during 2018.
In turn, export data should benefit from the strength of the euro area and growth in global trade; the full extent of this depending on whether exporters boost margins or volumes. Sterling, too, is now at a very competitive level. Sterling’s performance appears asymmetric, suggesting it is more vulnerable to poor economic or uncertain political news than it is responsive on the upside to good news.
Another positive in recent weeks is that the jobs market data remains strong. And there is continued evidence of inward investment into the UK.
Notwithstanding this, survey data suggests that corporate sentiment and investment intentions are fragile. And the last few weeks of the summer have also been characterised by apparent disagreement within the government over its Brexit strategy.
Finally, the summer has also witnessed an elevation of political risks. This has been highlighted by the worries over North Korea that we touched on here a few weeks ago. Clearly, this has the ability to spook markets again.
There are also a number of other political issues to keep a focus on in coming weeks and months. These include: (a) the Brexit negotiations. Although the next phase of talks is imminent, it may be only after the German elections on Sept 24th that the negotiations really move into the key phase. (b) September sees the start of the political conference season in the UK, beginning with the TUC and then followed by all the main political parties. The Labour Party conference is during the last week of September in Brighton, while the Conservatives meet during the first week of October in Manchester. Talk of another general election has receded, but nothing should be taken for granted. If the Prime Minister has a successful conference, then it would not be a surprise if she carries out a reshuffle in order to reassert her control. (c) Chancellor Merkel is expected to win Germany’s election and no-one seems to be predicting a surprise. (d) Then, in November, President Xi is expected to consolidate his power base in China, at the National People's Congress, the biggest political event there for five years. Given China's global importance, developments there might attract much financial market interest. Its impact might depend upon the mood at the time. It could, for instance, provide a positive boost to growth expectations if the focus is on the Belt Road, but equally if regional political tensions are high, it could trigger geopolitical worries.
So, for now the economic climate has justified the favourable financial market performance. In the next piece, we focus on inflation and on the challenge from a normalisation of monetary policy.
Please remember that when investing your capital is at risk.