Getting better with age?

This year is likely to resemble a more mature version of 2017, with healthy rates of economic growth and lower unemployment but still without meaningful inflationary pressures. Here, we look back briefly at 2017 and consider what might be up ahead for the major economies and financial markets.

Global Outlook

Feeling virtuous

There is no doubt that 2017 was a relatively auspicious year for financial markets. Risk assets were remarkably resilient and equities, in particular, powered ahead with several major indices reaching record highs.

Prospects for 2018 look similarly positive, with the world economy continuing to tick along nicely. A virtuous circle of higher business investment, lower unemployment, improving consumer spending and global trade is taking hold and there is little to suggest that this positive momentum is moderating. Indeed, we are seeing signs that the scars of the global financial crisis (GFC) are finally fading and ‘animal spirits’ – rising exuberance and confidence among consumers, businesses and investors – are reviving.

Against this backdrop, we expect above-average economic growth in most major economies this year and we should see equity markets continue to rise. The US will likely see the biggest improvement in growth, led by the ‘sugar rush’ from President Trump’s tax cuts. Data from the Eurozone, meanwhile, continue to signal robust growth. One slight shadow on this bright outlook is the UK, which will remain somewhat constrained by Brexit headwinds for the foreseeable future. A sharper-than-expected slowdown in Chinese growth, meanwhile, is a risk, especially given the country’s considerable economic and financial imbalances. However, our view is that the likelihood of a Chinese recession in the near-term is low.

A more politically correct year

After the rollercoaster ride of 2016, last year proved a more sedate affair in terms of politics. Although many of us were poised to see a continuation of the anti-establishment and populist political trends that shaped 2016, many of these feared possibilities failed to materialise. In the Eurozone, for example, elections were cited as the biggest risk in 2017, but long-term shocks were largely avoided. Indeed, some potentially positive outcomes emerged, such as French President Macron pushing for greater Eurozone integration and economic growth that far exceeded initial expectations.

There were of course developments in Washington too in 2017. In a year that was largely marked by evidence that, once again, the system of checks and balances can temper a president’s efforts at sweeping policy changes, we also saw that the system can sometimes move with surprising speed, with the passing of President Trump’s much vaunted tax bill. The current US administration also moderated its stance on trade in the face of stiff domestic opposition. Yes, NAFTA (the trade treaty between Canada, Mexico and the US) is being renegotiated, but trade wars have so far been averted and the US continues to import a large Share of global exports.

But just because markets coped with political and geopolitical issues in 2017, it does not necessarily mean the same for 2018. Possible sources of geopolitical volatility this year could include: North Korea; elections in Italy in spring; tensions between Saudi Arabia and Iran; a failure to renegotiate NAFTA; and multiple potential outcomes from Brexit negotiations. The political calendar of emerging markets is busy this year, with elections across a range of economies including Brazil, Mexico and Russia. This could add policy uncertainty into the mix for these regions.

An inflated view of the world

A key factor to watch this year is inflation. In 2017, a variety of influences restrained inflation at very low levels, so much so that Janet Yellen, then chair of the US Federal Reserve (Fed), admitted that “inflation is a mystery” and an “unexplainable surprise”. Historically, declining unemployment, as witnessed in the US, Japan, Germany and the UK, is usually closely followed by healthy increases in inflation. However, this relationship has weakened significantly since the GFC and, currently, there are very few signs of inflationary pressures building.

We do expect headline inflation in the larger economies to rise moderately this year, and we are mindful that a significant inflationary surprise, negative or positive, could trigger a sharp reaction in markets.

We expect above-average economic growth in most major economies this year and we should see equity markets continue to rise

Resuming ‘normal’ service?

Most central banks have remained cautious in terms of removing accommodative monetary policy and ‘normalising’ their actions. The Bank of England tentatively began to raise interest rates at the tail end of 2017, while the US Fed has moved quickest; raising rates three times in 2017. It is expected to move a further three times this year. There has been less to see at the European Central Bank, which seems broadly comfortable with its current stance on interest rates.

Inflation remains an important trigger for central banks to abandon their current policy stance and take a more aggressive tack in terms of raising interest rates. Therefore, investors would do well to watch for signs of strong economic growth and increased labour costs. In the absence of this though, monetary policy is likely to remain supportive in most major economies.

We are seeing signs that the scars of the global financial crisis are finally fading

What could possibly go wrong?

As always, there are risks to this relatively benign outlook. A policy mistake by central banks, where interest rates are raised too much or too quickly, could upset the apple cart. It never pays to be complacent but there are few signs that this risk is currently brewing.

Of course, political risks, which are often unpredictable and sometimes unforeseen, remain ever present and could derail the recovery. However, an outright trade war between the US and China, nuclear warfare on the Korean peninsula or an election result that triggers the breakup of the Eurozone, look unlikely. We therefore do not see the current political environment posing any immediate danger to the current state of affairs.

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