Maybe that impressive portfolio of 14 major titles isn’t done growing after all. Despite a few worrisome signs, we think the same of the U.S. economic cycle. While the current economic cycle approaches record length, we see scope for optimism with further bright days ahead.
In September, BMO’s global multi-asset team convened in London for our annual secular forum, where we evaluate the world from a longer term perspective to formulate our market expectations over the next five years. The team discussed several topics currently occupying the minds of investors, such as the escalation of the so-called trade wars and the potential for a U.S. recession in the next one to two years. We offer our views on these topics below along with our perspective on market-moving events in other key regions.
Everyone loses but some lose more
Trade tensions intensified in the third quarter as President Trump announced additional tariffs on $200 billion of Chinese goods at a 10% rate (potentially rising to 25% in January 2019), while China responded with 25% tariffs on $60 billion of U.S. goods. However, we continue to have a more benign view than consensus on trade, reflected in the modest risk-on stance in our portfolios. While concerning, the direct impact of the tariffs implemented and proposed thus far remains small and we believe the U.S. and China will reach a deal. In addition, we have yet to see “secondorder” effects from tariffs, such as lower consumer/business confidence and reduced spending, which would cause greater concern.
How dangerous is the selloff?
Emerging markets (EM) continued their selloff during the quarter. Fears of contagion increased as economic weakness in Turkey intensified and a few EM central banks raised rates significantly to support their currencies. China was not immune from the EM weakness, in part due to the trade dispute with the U.S. Chinese equities have sold off nearly 20% since the end of January. Our base case is that the pockets of weakness are country-specific, but we don’t think they will trigger a crisis in EM as they appear relatively healthy with better fundamentals as compared to previous periods of stress.
Resisting the tightening tide
The Bank of Japan maintained a highly accommodative policy as inflation is stuck well below its 2% target, we expect policy will remain largely stimulative in the coming quarters. Prime Minister Shinzo Abe was overwhelmingly re-elected and we believe stability and continuity in the political arena is positive for Japan.
Lower growth and persistent political risk
The outlook for Europe remains underwhelming as PMIs weakened and the European Central Bank (ECB) revised down its forecast for GDP. However, ECB President Mario Draghi noted that he expects a “relatively vigorous” pickup in inflation as tighter labour market supports wage growth. The ECB will halve its bond-buying program in October and end its balance sheet expansion in December, but interest rate should stay on hold until mid-to-late 2019. We continue to believe that the Italian coalition may be short-lived as it will have difficulty delivering on election promises. Finally, it was a challenging quarter for U.K. Prime Minister Theresa May. While we still expect a deal, time is running out and the probabilities of “no deal” and “hard Brexit” likely increased during the quarter.
U.S. equity earnings:
Going beyond the stimulus boost
When the fiscal stimulus package in the U.S. was announced in 2017, most equity analysts forecasted a onetime boost to U.S. equity earnings. However, earnings have remained exceptionally strong, with second-quarter results even managing to slightly outpace those of the first quarter. Earnings growth is expected to slow from its current pace, but growth should remain near 20% until year end. Even with trade tensions, S&P 500 companies with more global exposure actually reported higher earnings and sales growth in the second quarter as compared to their domestic-focused counterparts. While our “behavioural” assessment of U.S. equities has been very strong, we feel the bar for corporate earnings has been set relatively high. In light of very strong recent performance, we are considering modestly reducing our bias toward U.S. equities.
Positive, but Lagging U.S.
After solid economic performance in 2017 where real GDP growth topped 3.0%, growth is set to moderate to 2.1% this year and about 2% in 2019. However, a combination of higher borrowing costs, macro-prudential measures, elevated household-debt (chart 1), and concerns over competitiveness suggest the risks to this above-trend medium-term outlook are generally skewed to the downside despite evidence that capital spending in the commodity sector should remain a tailwind, notably after the confirmation of a $40bn investment in a liquefied natural gas terminal in Kitimat, B.C.