Market Perspectives: Five-Year Outlook

State of the world

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After eight years of growth (albeit moderate), and with signs of tightness in the labor market and deterioration in productivity, the U.S. economy appears to have entered the mature phase of the business cycle. But what are the prospects from here?

In the immediate term, there are some grounds for optimism. The U.S. is close to full employment, so modest wage rises are a possibility and these could support consumer sentiment and filter through into slightly higher inflation. Additionally, the impact of dollar strength is fading, and there is scope for profits to improve, so companies (unable to continue hiring so freely) could well increase capital expenditure.

Currently, the rate of expansion in the U.S. stands at around 2%, but longer term, there’s an argument that secular themes could depress growth to around 1.5%. First, technology-related gains in productivity are moderating. Second, lower birth rates are combining with an aging demographic to reduce the size of the working population.

Europe’s economy is muddling through. Given its inherent diversity, it should be of little surprise that the region is characterized by marked divergence between the economic fortunes of its constituent nations. The European Central Bank remains proactive in its efforts to stimulate the economy but with rates already into negative territory, the future effectiveness of monetary policy is increasingly being questioned. Low interest rates have also had significant negative implications for key sectors such as banking. This naturally raises the possibility of shifting policy emphasis towards fiscal easing. Within the confines of the European Union, however, such a move is problematic as it implies a more coordinated federal structure which, in turn, runs counter to the wishes of domestic parliaments and stands in contrast to broader political developments. Brexit has heightened doubts over the longer-term feasibility of the EU project, and issues such as migration have contributed to the upturn in populist politics, with parties at both ends of the spectrum making gains. These themes have harmed both spending and investment, keeping the outlook for Europe’s economy relatively lackluster.

For the UK, Brexit is likely to dominate in the short to medium term, with discussions over both the timing and negotiations affecting corporate decisions, UK stocks, and continuing to have a big impact on sterling. Despite this uncertainty, economic data has remained relatively robust with the purchasing managers’ index showing continued expansion. Expectations for growth longer term are in a relatively wide range, but the general consensus is that the trend will be downwards from here, with short-term forecasts cut heavily post the referendum result.

The Bank of England was quick to act, posting the referendum results, which cut base rates from 0.5% to 0.25%. However, there are a number of commentators who think this could have been more of a knee-jerk reaction to appear proactive and that the move was not necessary and could perhaps even be detrimental. Productivity is a cause for concern, and together with the more clouded outlook for inflation, this could spell a good time for policy to shift from monetary to fiscal, i.e., government spending and using the tax system to encourage private investment.

Turning to emerging markets, since mid-2013, a huge amount of money has been pulled out of emerging markets, and we have only just started to see this flow reverse. An improvement in sentiment has been driven by a whole host of factors, from the emergence from recession by Brazil and Russia to some structural reform stories in Argentina, Indonesia and India. This has been seen in emerging market debt spreads, which peaked in February 2016 and have fallen materially since then.

2016 has also seen the convergence of two trends. The first is the fact that, for the first time since mid-2011, non-oil commodity prices have seen consistent, albeit small, upwards momentum. The second is that emerging market current account deficits began to fall from mid-2013, hence, perceived risk fell and returns rose. Therefore, it could be reasonably argued that emerging market fundamentals have troughed.

Source: Citi Research as of August 2016.
Source: Citi Research as of August 2016.
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Sources: Bank for International Settlements, Haver Analytics, Citi Research as at March 2016.

In China, capital outflows have contributed to problems in emerging markets. A big build-up of external debt between 2009 and 2013, originally accumulated to finance carry trades, is being unwound. The speed of that unwinding is affected by U.S. monetary policy as it was largely short-term U.S. dollar currency that was borrowed. Although capital outflows from China continue in 2016, it is not in a way that generates global risk aversion (as it did in 2015) largely because the People’s Bank of China is pursuing a policy of moderate and gradual exchange rate depreciation. However, China’s growth model is creaking and it has only limited policy tools available to engineer a soft economic landing.

Out of ammo – passing the baton

Since the financial crisis, central banks and their actions have been center stage. Globally, central banks have deployed over $12.3 trillion since September 2008, in various quantitative easing initiatives, and cut interest rates towards zero (and even beyond). Can their efforts be judged a success? On balance, yes. Economies have grown, asset prices have increased and the threat of deflation has largely been mitigated.

Despite this progress, the current lack of economic strength in many regions (and globally in aggregate) means that more needs to be done. After years of action, however, there is limited scope for monetary policy to provide further impetus, meaning that the likelihood of fiscal measures being employed has increased.

Fortunately, a period of austerity in countries like the UK means that there is greater flexibility to boost activity through spending in areas such as infrastructure. Indeed, the passing of the baton from central bankers to governments has already begun. Canada is already some way down the path; others will likely follow. Shortly after his election, Prime Minister Trudeau outlined ambitious plans aimed at fighting off the recessionary threat by increasing Canada’s deficit and spending big on infrastructure. In Japan, tax increases have been postponed, and in the UK, the new government has shifted the emphasis from deficit reduction to a more flexible and pragmatic approach that includes greater spending. In the U.S., meanwhile, Donald Trump looks set to fulfill key promises from his election campaign to increase infrastructure spending.

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Populism providing additional impetus

Shifts in the political backdrop have also helped drive the move towards fiscal measures. For many individuals, the period post the financial crisis has been one in which they have seen their wages fall while, at the same time, they have become increasingly unsettled by factors such as automation and migration. Whether real or perceived, these factors have created greater skepticism towards centralized decision makers and structures like the EU, and a shift away from the center towards more populist rhetoric and policies. Those politicians and parties appealing to marginalized voters have gained ground, with protectionism and an increased willingness to spend and/or cut taxes: key themes on both sides of the Atlantic.

 

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