Of course, the health of the US economy, and more specifically, the direction of US inflation, has implications far beyond the United States’ borders. Inflation is certainly on the up – after the unexpected weakness in 2017.
So, what’s changed? A normalisation of housing and medical costs has contributed, but more importantly, we have seen wage inflation building and rising import prices are feeding through. Together, these factors mean inflation – using the Fed’s preferred measure of the Personal Consumers’ Expenditure Deflator (ex food & energy) – is heading above the 2% target, which in turn means a likely continuation of the tightening cycle.
The resurgence of Europe’s economy was one of the stand-out themes in 2017 but this year we’ve begun to see forecasts being revised downwards. The situation is still reasonable though with growth remaining above trend and unemployment easing. Germany’s powerhouse economy is doing comparatively well and this bodes well for the region more broadly. It also suggests that rates may finally move upwards at some point in 2019.
For now, the cost of borrowing remains low, and small and medium sized businesses (a significant driver of growth) are able to access capital at a relatively low cost. Importantly, financial institutions are now willing to lend to companies – a situation that stands in sharp contrast to the position a few years ago.
Given the services surplus, the prospects for that part of the economy are arguably more pertinent, and financial firms – like ourselves – are already transitioning towards post-Brexit operating models. There will be some setbacks and contraction for the financial sector but when you balance the UK’s attractions against some of the challenges associated with operating on the Continent, it is difficult to believe that London’s position is really under threat.
A similar picture emerges for non-financial services based in the UK – the customers for which often originate outside of the European Union anyway. Of course, it must be recognised that Brexit makes the UK less attractive than it was and there will be plenty of bumps ahead.
Rising inflation and higher interest rates aren’t good news for government bonds so we are relatively cautious on the prospects for the likes of US Treasuries. Additionally, the support Treasuries have historically enjoyed from overseas investors has waned. Elsewhere in fixed income, valuations do not look particularly compelling.
The prospects for equities appear brighter but not spectacularly so. The recent earnings season in the US has been very positive – expectations heading into it were high and investors weren’t left disappointed. Given that the market likes upwards revisions (and doesn’t like disappointments), this is a headwind for US equities and risk assets more generally. Despite recent political concerns, the prospects for European equities remain encouraging – euro strength has provided a headwind to performance recently but the economic backdrop is robust and there is greater scope for earnings expectations to be exceeded.
More generally, we have a preference for developed markets over their emerging counterparts. Economies are buoyant whereas dollar strength, higher interest rates and political uncertainty all suggest emerging markets will be characterised by greater volatility without (at this stage) materially higher returns. We have trimmed exposure to emerging markets.
Recent trade tensions cast a shadow over the world economy as well as risk assets, and have supported US Treasuries in the process. We are worried about the aggressive actions of the White House but anticipate that they will not implement their threats. Nonetheless, it makes us nervous.