Mid-year review: so far, so good

Mid-year review: so far, so good

Halfway into the year, let us pause to reflect on the global economic and financial situation. The good news is that many of the risks outlined in our 2017 outlook have abated, buttressing our view that a worldwide recession is not on the horizon. Rather, our favourite economic indicators point to continued and relatively broad-based expansion. But we must also acknowledge that a number of these indicators have begun to level off, suggesting some maturing of the cyclical upturn – at just the time when central banks are shifting away from crisis-management mode.

A slow but steady global growth environment, with limited inflationary pressures, has enabled central banks to maintain very accommodative liquidity conditions for a number of years. As the recovery endures and broadens – extending now even to the Eurozone and Japan – central banks are beginning to take or at least consider tightening measures. Albeit still positive, growth in global liquidity, defined as the combined balance sheets of the Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BoJ) and People’s Bank of China (PBoC), thus looks set to slow down next year.

This is not to say that credit to the real economy will slump. After all, central bank liquidity injections were aimed first and foremost at preserving the financial system – not promoting growth and employment. The US is a case in point: while Fed money was the main driver of aggregate monetary growth between 2009 and 2014, there has since been a shift to commercial bank money, which in turn enabled liquidity to migrate from the financial to the industrial sector. The recent drop in US commercial and industrial loans did admittedly come as a surprise, particularly in light of strong business confidence, but it could be partly attributable to energy companies having regained access to the bond market, hence needing to rely less on bank loans than during the oil price slump.

In the Eurozone and Japan, credit trends have been steady to stronger, with surveys of bank lending confirming the improvement. There too, with a lag of few years relative to the US, commercial banks are taking over from the central bank in driving money growth.

Credit-ridden China is the relative exception to this brighter lending picture. Loan growth has been easing for over a year now, held back by a number of government measures: higher short-term rates, restrictions on shadow lending and housing curbs (impacting mortgage lending). But given policymakers’ intent to maintain ambitious growth targets, we do not believe that fears of a collapse in Chinese credit are warranted.

How about evidence that more expansionist fiscal policies will also help offset the shift in central banks’ stance? While most advanced economies should indeed see modest fiscal easing over the next two years, the detailed picture on this front too is mixed, with fiscal paths set to vary substantially by country. Little incremental fiscal tightening is to be expected in the Eurozone. The UK should slow its pace of fiscal consolidation, as Brexit starts to bite into economic growth. In the US, we expect Congress to eventually lower corporate taxes, although the size of the cuts will fall short of what the President has suggested. Driving the compromise will be the fact that both Congress and the Trump administration need a political success ahead of the mid-term elections. Ironically, fiscal stimulus is coming to the US just as the economy has reached full employment. Finally, China is making a structural transition to large budget deficits. Policymakers’ desire to rein in credit growth will only add to the impetus to find new sources of aggregate demand.

All told, the “soft goldilocks” environment that has propelled financial markets ever higher remains very much in place. Neither an inflationary drift nor a recession seem likely scenarios for the near future, warranting a continued risk-taking stance in portfolios. Elevated equity valuations are, however, a cause for concern, particularly in the US. We prefer to focus on regions where the economic cycle is less advanced, hence liable to boast greater earnings stamina. Emerging markets and the Eurozone thus remain our favoured regions – the latter also standing to benefit from dissipated political risks and a near climax in Fed-ECB monetary policy divergence, which should strengthen the prospects for the single currency.

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