Weighing Stronger Global Growth and Higher Interest Rates

Oct 2017 Issue

As the current economic expansion edges closer to the decade mark, there seems to be a peculiar state of affairs developing in the financial markets. Specifically, investors seem to have gone from panicking at the mere thought of higher interest rates to a “What? Me Worry?” attitude. Some look at the lack of concern as being perfectly normal since higher interest rates should also mean a stronger economy and the psychology of investors has finally shaken off a reliance on low interest rates. Others will say that there are reasons to worry and complacency is never a good thing.

As seen in Figure 1 below, the complacency is best reflected through the lack of volatility in equity markets. Frankly, there is a lack of worry about pretty much anything—whether it is North Korea, rising disunity within the European Union, or armed conflicts that show no end in sight. Even concerns about market valuations are being drowned out. Against this backdrop, some market observers have come to wonder if investors are too complacent.

Figure 1: CBOE Volatility Index

Source: Thomson Eikon. October 17, 2017.

Figure 1 - CBOE Volatility Index

In part, the complacency is being fueled by investors choosing to focus on the rebound in corporate profits and the growing global economy. The International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) have moderately raised their growth forecasts for the global economy. In turn, this should benefit corporate sales and profits.

Recently, the IMF has gone from calling global economic growth the “new mediocre” to a more upbeat assessment where it has increased its economic growth forecast to 3.8% this year from its earlier projection of 3.7%. All of this seemingly good news comes against a backdrop of markets understanding that the low interest rate punchbowl in most of the developed world is or will be taken away.

Employment Stoking Inflation

The US Federal Reserve has continued to defy skeptics and stuck to its plan of raising interest rates slowly but surely. The skeptics believe that since inflation is still below the stated 2% policy target in the US, then the US has no need to raise interest rates. They also fear that just as the US economy is showing resiliency, the lifting of interest rates could upset an economy that many feel is still not at full steam. The latest analysis of the Federal Reserve’s voting members shows that there is consensus for one more interest rate increase in December of this year and three more rate increases by December of next year.

The Federal Reserve is working under the assumption that the low unemployment rate in the US will eventually trigger inflation and if it moves too slowly, then it will have to engineer a drastic economic slowdown to get inflation back under control. Essentially, they are saying raise a little now or raise a lot later.

Furthermore, the Fed has forecasted for the unemployment rate to continue to fall towards 4.1%. This is a fair probability as the economy is currently generating 175,000 jobs per month in 2017 while only 100,000 per month are required to keep the unemployment rate steady. Thus, labor market strength is a potential inflationary pressure because it can cause wages to rise and then filter into prices. Federal Reserve Chair Janet Yellen stated in a speech this month to central bank officials from other countries “… we continue to expect that the ongoing strength of the economy will warrant gradual increases in that rate to sustain a healthy labor market and stabilize inflation around our 2 percent longer-run objective. … I expect inflation to move higher next year.

Restart of the Trump-Trade?

One reason that equity markets might be willing to shrug off the Fed’s apparent signaling of future interest rate increases is that great hope is being generated by the prospects of the Trump Administration getting its tax cut package approved by Congress on the second attempt. Many expect the plan to act as a stimulus to the economy and boost corporate profits by about 7-12% at best by reducing taxes for business. This could be considered the restart of the “Trump Trade.” But one caveat to optimism around corporate tax cuts is that corporate profits as percentage of GDP are at record highs. Any further boost to profits could prove to be transitory – especially if interest rates continue to rise. A question which remains open is whether or not the equity markets have jumped the gun and priced in too much corporate tax reform.

The Beginning of the End

An additional policy measure from the Federal Reserve that was affirmed recently is that there will be a slow winding down of the $4.5 trillion in bond assets, which it accumulated in its attempt to force interest rates lower. To put this figure in perspective, the assets on the Fed’s balance sheet sat at about $870 billion before the start of the last recession.

Both the bond and equity markets have taken the Fed’s announcement on the winding down of its bond holdings in stride. This is in part due to the fact that this is a signal that things are slowly returning to normal. But the markets are also taking the policy change calmly because the pace at which they will wind the holdings down is extremely gradual. The Fed will start at $10 billion per quarter and then increase by a further $10 billion per quarter and top out at $50 billion per quarter. It will take a while to put a dent in $4.5 trillion of bond holdings at that rate. As Fed vice-Chair Stanley Fischer told CNBC viewers last week, “I wish the circumstances were such that going faster was the right policy…But given the uncertainty about the inflation rate approaching the 2 percent target, we have to be more careful than full speed ahead.”

Some Urge Caution

Some within the Federal Reserve believe that there is no reason to raise interest rates too much further if at all because they believe that the Fed’s economic models need to be recalibrated to reflect a world in which pricing pressures are held in check due to the influence of technology and other structural forces that are realigning how the economy works. They argue that any strengthening of inflation is likely to prove to be transitory and therefore, the Fed should move carefully before raising interest rates.

The Fed has publicly admitted to some surprise that the bond markets have taken its tightening bias so well. It seems that investors believe that the Federal Reserve is on inflation watch and will stamp it out before it is a problem. Many continue to believe that inflation will remain stuck at 2% or less for some time.

US Growth Getting Help From Abroad

As we have commented in previous newsletters, we continue to see favorable trends towards economic growth across most of the globe. In North America, we are seeing the Canadian economy surprising both economists and the markets by showing economic growth that has led the G-7 nations in 2017. Recent forecasts from the OECD have raised forecasts for this year towards 3% growth from 2.50% for both 2017 and 2018. If Canada is able to hold onto the 3% GDP growth level, it would end a five-year stretch of below 3% growth, which is currently tied as the longest record since 1926.

Canada’s economic strength has caused economists to revise upwards their projections for the economy for 2017 and 2018. The Bank of Canada will likely sit tight for a couple of quarters before deciding on whether or not to raise interest rates further. This is because Canadian export data shows that exports have fallen for the third month in a row leaving the economy reliant upon government spending and an over-indebted consumer. A recent forecast from Macquarie Capital Markets stated that the Canadian economy is set to reverse sharply lower in Q3 2017. While this is a call that is far from the consensus, if it were to bear out, then the market will shut the door on Canadian interest rates rising further and this would put downward pressure on the Canadian dollar. The weakness is expected to be led by weak energy and auto exports. Shipments of both of these have been falling at the fastest pace since the last recession. Still, a decline of that size in Canadian GDP would be a surprise given recent momentum.

Overseas Growth

Outside of North America, Europe and Asia continue to show stable growth and have largely shaken off the most apparent effects of the downturn in 2008. An uptick in Asia’s economic growth rate would do wonders for the subpar global economic expansion of the past 10 years. Asia represents almost 60% of the world’s population and offers a longer high-growth runway than the developed economies of North America and Europe. But within Asia, the outlook is splintered.

Over half of Asia’s economy is represented by Japan, India, and China. Japan is experiencing its longest run of economic growth in a decade with six consecutive quarters of growth. Given two decades of malaise—this is not high praise. Recent data shows that business investment is once again slowing down and will weigh on economic growth. Current forecasts by Capital Economics show that the economy will turn in a 1.7% expansion this year and 1.2% next year. It is almost a certainty that Japan will not be raising interest rates this year or next.

India is a much more complex equation as its economy continues to grow at 6-7% annually. Recent reforms around tax and currency have brought down growth expectations for this year and early 2018. Given its relatively younger population, it is expected that India could be on track to become the third largest economy in the world over the next decade and begin growing faster than China on a sustained basis.

China’s economic outlook has been constantly clouded by the excessive bad debt and overbuilding in construction and industrial capacity. Yet, each year the country manages to grow its economy by over 6.5% annually – though some skeptics question China’s GDP calculations. But if we take the official figures as they are, then China will continue to be a key contributor to global growth. Regarding China, there is little we can say that has not been said before. The bulk of Chinese growth is coming from debt, which is growing at a much faster pace than the economy. Markets are also noting that the Chinese government has indicated potential measures to make sure that the capitalist system does not overtake the influence of the government.

Hopes for Europe’s economy continue to rise as it has begun to churn out slow and steady economic growth. The European Central Bank has pushed the monetary policy envelope to get things moving again and after several years, it is showing some positive outcomes for the economy. But the same old structural issues of uncompetitive industries, high wages, and low productivity still cast a dark cloud. In addition, uncertainty around Brexit, the Spanish separatist referendum in Catalonia, and disagreements within the EU about immigration policies have increased political uncertainty. Jean-Claude Juncker, President of the European Commission, stated this month that he believes if Catalonia became independent, other regions would follow. He also added “…I don’t like that. I don’t like to have a euro in 15 years that will be 100 different states. It is difficult enough with 17 states.”

For Europe, the UK’s Brexit is the other elephant in the room. Negotiations between Britain and Europe over its withdrawal from the EU have gone essentially nowhere and Britain’s deadline is March 29, 2019. While the OECD has upgraded its forecast for economic growth for most of the world, the UK was left off of the list. Further complicating matters is the fact that inflation has moved up to a five-year high of 3%.

Volatility Has Become Scarce

Thus far, markets have been able to shrug off most any concern and volatility remains at or near historic lows. But volatility has a habit of making an unexpected return in financial markets. Volatility can be helpful as it puts assets on sale which can be purchased at better prices for long-term investors. Just what causes the return of volatility is anybody’s guess.