As we move closer to the end of the calendar year it is appropriate to review the current major global economic themes we are monitoring and how we think they may unfold.
The expansion of the global middle class and the impact on global growth
As we have previously discussed in our articles “we live in interesting times” the global middle class is expanding at an unprecedented rate. It is middle class income and activity that drives business investment and moves an economy into a higher gear.
Household income drives private capital expenditure
The increase of around 180 million people per annum to this middle class sector is driving global consumption and income patterns. In particular, China is at the forefront of this new fiscal pulse and we are seeing synchronised emerging growth throughout the Asian region.
Overall, global growth is improving in this region and elsewhere. Importantly, expansion in the US is on a solid footing. The opportunity for fiscal reform has appears to have been squandered and the forthcoming tax cuts are likely limited to small corporate and personal income tax cuts. Unfortunately these adjustments are overly reliant on a trickle down philosophy rather that a sharper focus on the middle class.
The cyclical lift in European growth had largely been a function of stronger external growth among its trade partners. Importantly, growth appears to be evolving where this lift is now likely to become more enduring. Rapid falls in unemployment, lifts in real median incomes, are in turn lifting European based consumption and business activity. Importantly, business activity is no longer being severely constrained by banks not wanting to lend to them. In part this is due to a shift in policy from the ECB by allowing long dated yields to rise relative to negative cash rates; banks can lend at rates higher than their funding costs.
This is the important evolution in our investment outlook. With solid US and China growth rates, but without Europe, global growth is patchy and stuck in second gear. With Europe becoming more self-sustaining, it lifts global growth through its own contribution and adds to other regions via trade thus creating a more virtuous cycle.
Where is inflation in the current environment?
Developed economy core inflation is below most central bank targets as it is constrained by globalisation of labour and product markets. While unemployment in Europe is falling rapidly, it is still elevated. In contrast, the US and Japan have very low unemployment but there is little wage inflation largely due to the consistent expansion of the global labour force.
Energy prices are unique in that they are generating headline inflation shifts. This is, at the margin, helpful in that it allows a supportive narrative to justify the major central bank to shift away from their ultra-loose monetary policy settings.
Why do we have subdued developed economy business investment?
In addition to weak median income growth, subdued business investment in the developed world has been a result of central bank policy overreach. Central Bank balance sheet expansion (QEs and FX reserves) has contributed to the global excess of saving. Currently, Japan and China are adding to this excess saving that has been holding down yields and consequently investment income. The follow on impact of course is the crowding out of investment markets and the global hunt for yield which pushes asset prices higher and results in a more expensive starting point for capital expenditure.
Since our last update, key announcements have been made by the Fed and ECB. The US Federal Reserve will be reducing its balance sheet reversing QE. Europe announced the intention to the reduce the volume of bond purchases to €30bn per month
Although Central Banks will continue to unwind their QE programs, cash rates apart from the US will not rise we think, until 2019. While the US is already lifting cash rates, it will be difficult to lift too much further without Europe increasing its cash rate. Doing so in isolation, the USD would rally too far, thus dampening export activity as well as inflation. This is why we believe European fortunes are so pivotal for the world.
Major Yield curve changes year to 30 Oct 2017
What about Politics?
Despite all the rhetoric, in particular around the Trump presidency, we view politics as just noise that will be increasingly looked through by markets. The reality is that in spite of all the colour that is continuing in the United States political arena and indeed even with what is happening in our own backyard in Canberra – most economies are doing well. Indeed, we anticipate that US growth will firm as Trump’s fiscal policy is implemented. This will have an obvious flow on effect on the global economic landscape.
Where does Australia sit?
Australia’s economy is expanding solidly largely driven by mining exports and building construction. Underpinning construction is the ongoing large population growth which is close to 400,000 people per annum. Despite the big increases to the size of total labour force, employment growth in Australia remains strong averaging 23,000 positions per month; good enough growth to mean that unemployment is not rising, nor is hidden unemployment.
The significant expansion in the labour market is ensuring wages are not growing, resulting in weak to non- existent middle class income growth. Business investment and consumption is therefore weak, meaning that Australian growth is stuck in second gear. With little wages and inflation pressure there is no case for RBA to lift cash rates.
With regard to the exchange rate, China’s expansion is causing the AUD to stay unhelpfully high, thus dampening the non-mining export sector.
At our recent Investment Advisory Committee meeting, we reiterated our view that US and Chinese growth is adding to global growth significantly. However, our view has evolved such that we now see European growth transitioning from being fragile and cyclical to an economy which is more self-sustaining and to one which can contribute to world growth. Although we don’t see inflation lifting, aside from cyclical lifts in the headline rate due to energy price rises, at least core inflation is now modestly supportive for the major central banks to continue the path of unwinding their asset purchase programs. Accordingly, we expect longer dated interest rates in major bond markets to drift higher. Australian and European cash rates are unlikely to lift over the next year.
Our current strategy involves currently recycling capital generated from short duration positions back into themes that look for higher long end interest rates but stable shorter dated interest rates, including high grade corporate bonds. We distinguish between high grade corporates and high yield corporates. We are increasingly concerned with the passive build-up of these positions in ETFs, in an environment where some unwinding of the global hunt for yield could emerge.