Global Economic and Market Outlook for 2018

Gavyn Davies, Chairman, Fulcrum Asset Management

After many years of persistent downgrades to consensus GDP forecasts, 2017 hasseen the first upgrades since the Great Financial Crash…

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The upgrades in forecasts for the advanced economies have been especiallyimpressive…

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The upgrades in forecasts for the emerging markets have been much smaller thanfor the advanced economies, but have still been in the right direction…

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While the global expansion has been gaining strength, there has been a decline ininflation expectations during 2017 – we have been in a regime of real outputexpansion, NOT reflation…

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The dominant regime since February 2016 has been of global expansion, and theperformance of many (most?) macro asset prices has been driven by this regime…

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The fiscal stance in the US and the EA has been easing from 2015-17 and is likely to ease further from 2017-19 (seered zones below). Japan would move in the opposite direction if the planned sales tax increase is implemented in2019 – which looks dubious. (Source: OECD)….

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Monetary policy normalisation, measured by the level of policy rates, still has a very long way to go (Source: OECD) …

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Many analysts argue that the rise in asset prices has been linked to global QE. Nowthat the Fed and BoE have stopped increasing their balance sheets, QE is nowdependent mainly on the ECB and BoJ, both of which may taper asset purchasesnext year. Peak QE is now well in the past…

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In the developed economies,the GDP recovery has beenheld back by a below averagerecovery from the slump ininvestment that happened in2008-09. This headwind isnow abating, especially in theEuro Area, where the recentrebound in investment hasbeen quite strong. Thisreduces the forces of “secularstagnation” that have heldback the global economy andhave reduced the equilibriuminterest rate, r*…

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The Washington Post points out that real GDP in the US now slightly exceeds potential GDP (asestimated by the CBO) for the first time in the recovery since the Great Financial Crash. This couldbe a warning signal that the top of the US upswing is close at hand, since real GDP does notnormally spend that much time above potential…

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The Fulcrum nowcasts have performed fairly well this year, picking up the strongrecovery in the EU, and the robust growth in Asia, very early. The nowcasts were,however, somewhat over-optimistic about growth in the US. The latest figuresshow global activity growth remaining well above trend, especially in theadvanced economies. Based on these figures, the models report that recessionrisks are very low heading into 2018…

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Latest nowcasts show thatactivity growth in the US andthe EU remains very strong, ataround 3.5-4% in both cases,This is well above trend, soeconomic slack in botheconomies is now decliningquite sharply. Growth in Japanalso remains notably above thelong term trend. China hasrecorded a moderate slowdownsince the 19th Party Congress,but this has not so far becomevery serious…

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Latest forecasts produced bythe nowcast models suggestthat activity growth in the USand the EU will remain aboveconsensus in 2018, though thegrowth rate will gradually fallback towards trend rates.Recession risks on a 12 monthview continue to look very low,according to these models. InChina and Japan, the modelssuggest stable or slightly lowergrowth rates, perhaps a littleabove trend. The globalupswing is therefore nowpassing its peak growth rates,but the slowdown next year willbe a return to normal, ratherthan the onset of recession…

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Although economic slack has been diminishing and the labour markets have been tightening, theFulcrum models of underlying inflation are showing absolutely no sign yet of any rise inunderlying price inflation in the US, and very little sign of any rise in the Euro Area. This is the onlyremaining factor preventing the Fed and the ECB from turning more hawkish…

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Although wage increase in most advanced economies remain low, there are now some signs that labour shortages are becoming severe…

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Although low wage growth in the US and other economies seems to suggest that the Phillips Curve has flattened since the Great FinancialCrash, leading policymakers in the Fed have been reluctant to conclude that the PC has disappeared altogether. Using slightly differentvariables to measure labour market slack and wage increases, the PC does not seem to have changed much …

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The Taylor Rule may become somewhat more important in the setting of interest rates by theFed, following the major change in personnel which is now underway. Most versions of the Ruleindicate the current setting of rates is slightly or considerably “behind the curve”. Even in theEuro Area, the Taylor Rule is now starting to point to the need for higher short rates…

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Although the Fed has been trying to tighten monetary policy since 2015, financial conditionshave actually moved in the opposite direction because of rising equity prices, declining creditspreads and a falling dollar. This easing in the FCI has been very supportive of US and globalgrowth in 2017, and a significant reversal in these indices could be the major downside risk to USgrowth next year…

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In the developed economies as a whole, financial conditions have eased by 125 basis points since the China crisis peaked inFebruary 2016. According to calculations by Jan Hatzius of Goldman Sachs, the impulse from financial conditions on the GDPgrowth rate has shifted from -1% to +0.7% over this period. This effect is now peaking and will begin to reverse soon, even if FCIsare stable from here on. A tightening in the FCI would obviously increase this headwind for global growth…

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The markets continue to price verydovish behaviour by the Fed and theECB next year. Only one hike is pricedfor the Fed in 2018, compared to the 3hikes shown in the Fed dots, and 3-4hikes priced by the main economicforecasters like GS and JPM. Some ofthis gap may be explained by a negativerisk premium on US rates, but theredoes seem to be considerable scope fora hawkish surprise on US policy ratesnext year. In the Euro Area, the marketexpects no change in rates at all nextyear, which is broadly in line with theECB’s recent guidance…

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China may slow in the next year as monetary and fiscal policy becomes less supportive of growth, and financial deleveraging takessome of the steam out of the property sector. However, we do not expect the new policy regime to tolerate a sharp drop in thereal GDP growth rate, and the risk of a major implosion in the credit bubble still seems to be under control for the time being…

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A 1% downward shock to Chinese GDP growth islikely to reduce growth in the advancedeconomies by 0.1-0.2 per cent over two years,while having a meaningful negative impact oncommodity prices…

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Metals Prices

Oil Prices

Equity valuations are in red territory for the US, Europe and Germany. They are in amber territory for the EM, and Japan is the only majoreconomy where they edge into green figures. Real bond yields obviously flash red everywhere, as do credit spreads. Because bond yieldsare so low, ERPs are not as stretched as P/Es. The dollar is slightly overvalued, with most other major currencies undervalued against it,especially the yen. All these valuations are relative to 20 year histories, calculated by Morgan Stanley…

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Fulcrum maintains aregular BVAR model forthe main asset returns inthe US. This modelproduces forecasts forasset class valuations,interest rates, inflationand GDP. The latestforecasts for 3 year realreturns are shown here.Equities and credit areexpected to produce lowsingle digit returns, whilebonds and cash producenegative real returns inthe model. The expectedreturns on risk assetshave fallen fairly sharplyduring 2017, reflectingthe rise in valuationsover the recent period…

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The graph shows thevaluation of the majorcurrencies against the USdollar, using an averageof three differentmethods to calculate FX“fundamental”valuations. (Negativenumbers imply that thecurrency in question isundervalued against thedollar.) Most currenciesare undervalued atpresent vs the USD, butthe decline in the USDthis year has reducedthese undervaluationsconsiderably. The EUR isnow undervalued by11%, compared to 22% atend 2016…

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Calculations by Fulcrum fixed income research

Currency valuations vs USD (-ve implies undervalued vs USD)

EUR