DR.CHENJIAZI ZHONG

In Brief

• U.S. growth continues to hum along at a moderate pace
• More hard evidence of European economic expansion
• Capacity, labor, and price pressures accruing in Japan
• In China government and private PMIs embody soft-landing
• The Brexit/politics dulled 2Q17 economic activity in the U.K.
• Equity markets performance was upbeat in 2Q17
• U.S. government bonds rallied for most of the 2Q17 before retreating in the final week, reflecting a mix of softening inflation, falling commodity prices and firming monetary policy expectations.
• Several ingredients create a generally supportive outlook for risk assets: Remain constructive on risk assets

Data flow over the course of 2Q17 confirmed that the global economy locked in a higher growth rate in 2017 after accelerating in 2H17. Measures of corporate sentiment moderated somewhat but remained healthy. Consumer sentiment was robust across developed markets (DM) and global export volumes accelerated modestly. International DM, led by the eurozone and Japan, were points of strength. Emerging markets (EM) were stable on balance. The U.S. economy rebounded after a soft 1Q17, bringing its first-half average growth rate to about 2%. The persistence of growth rates and positive sentiment were constructive fundamentals for equities. The supportive undertone was evident in decent upward momentum in global earnings revisions, and implied in the equity outperformance relative to other asset classes.

Slowing inflation was a lynchpin for the decline in government bond yields in 2Q17. Much of the reflationary impulse in 2H16 can be explained by evidence that global inflation was picking up, pushing nominal growth forecasts higher and garnering expectations that monetary tightening would follow. During 2Q17, the inflation outlook came under some pressure. For one, Brent crude prices fell 10%, bringing benchmark prices down nearly 15% year to date; OPEC officials believe, however, that inventory draws in July will double the levels in 2016 and will trend in the right direction. Indeed, weekly and monthly storage data are pointing to a tighter market by year end. With investors awaiting signs of a tightening oil market, July may be an important inflection point for sentiment. Inflation had been broadly softening even prior to the most recent oil price shocks.

In the U.S., the ADP nonfarm private payroll employment increased 158,000 month over month in June, and jobless claims remain low. The souring of U.S. relations will make it harder for President Trump to move forward on several matters with other nations; when it comes to North Korea, however, differences could be left at the door due to the urgency and severity of the matter. U.S. durable goods data for May indicated orders rose 0.2% month over month and shipments ticked up 0.1% versus contracting. U.S. growth continues to hum along at a moderate pace for now. Capex and employment are positively correlated to the U.S. economy as a whole.

In the EU, retail sales in volume terms continued to expand, which grew 2.7% in May compared to the previous year. This hard data is consistent with the elevated consumer and business sentiment in the region in recent months. Firms and consumers are reacting positively to the recent diminishing political uncertainty and anti-euro threats.

In the U.K., both the Services (53.4) and Mfg (54.3) PMIs were expansionary in June. Brexit- and general-election-related uncertainties have been holding back consumer and business spending for a few months. Panelists in the Services sector cited difficulties recruiting staff to fill vacancies as well as coincidently rising staff salaries, which may be the first sign of wage gains to come.

In Japan, the rises in services and manufacturing employment helped its rate of private sector job creation to reach the highest since September 2007. As has been the case in every month since November 2012, input prices faced by Japanese service providers rose in June. Moreover, Japan’s rate of inflation quickened to the sharpest in five months, amid reports of higher raw material and staff costs. According to The Guardian, Japan and EU expected to sign trade deal after a breakthrough in talks.

In China, new orders, output, hiring, and costs continue to ease. Yet, panelists remain optimistic as conditions are moderating. The Caixin Markit Mfg PMI bounced back to 50.4 in June, compared to contracting to 49.6 in May. The Services PMI declined fractionally to 51.6, but buoyed the 51.1 of the Composite index in June. In general, the milder China domestic growth becomes, the more incentive there is for policy makers to strengthen trade ties.

Thoughts

Several ingredients create a generally supportive outlook for risk assets: economic output at current levels, evidence that business cycles globally remain on a slow burn, and anticipated signs of firming inflation. The risk is best spread out more evenly across regions, with a tilt towards more cyclical markets like the euro zone, EM, and Japan. Investors should remain constructive on risk assets, with a broad-based regional exposure to equity markets.

Real yields are again leading the charge in 10-year yields. But inflation expectations, though lagging a bit, are drifting higher now too. Net, the relationship between these two now implies monetary policy is as tight as it’s been since last March, after easing for most of 2016 and 2017. The difference between the breakeven inflation expectation and the real yield may be interpreted as a measure of monetary tightness or even a first derivative on growth, with a higher number signaling looser financial and monetary conditions. Conditions in January of 2016 were at their tightest since the recession. Today, conditions are tighter than at the start of the year. Any further rise in real yields could start to weigh on risk sentiment.

The most powerful driver for yield curve flattening over the post-financial crisis period has been central banks’ active balance sheet policy, which has depressed longer-dated yields. Indeed, the rebound in bond yields towards the end of the 2Q17 has been mainly a function of heightened expectations of central bank balance sheet normalization this year. Federal Reserve statements suggest that its plan to let maturing securities roll off its balance sheet will shrink its holdings by $1.4 trillion over the next four years. As a result, an increased net supply of bonds, in tandem with a taper of asset purchases by the European Central Bank in 2018, will push up global yields. Spates of volatility over that period, as markets calibrate the pace and end points of this process, are to be expected.