Private Bank Outlook 2018

An aging cycle that’s still rewarding

Private Bank Outlook 2018

An aging cycle that’s still rewarding

This cycle is on track to become the longest in history

The global financial crisis cast a long shadow over markets and, in the years since, market commentators have grabbed countless headlines predicting another global downturn. And there has been no shortage of macro or market imbalances to cite: acute sovereign debt problems in the Eurozone, bubbly commodity and energy prices, a balance-of-payments emergency in China, just to name a few. But these imbalances were relatively localized to specific sectors and regions, and, as such, contained enough for the U.S. economy to keep the global cycle alive. Fast forward to today, these micro-recessions have allowed Europe and emerging markets (EMs) to recharge and take the lead in the global cycle, just as the U.S. expansion has started aging.

This global cycle will eventually end, but for this to happen, a combination of the following three conditions needs to be met:

  • (i) market and macro excesses in the U.S. economy need to build further;
  • (ii) interest rates and borrowing costs need to rise to “punitive” levels;
  • (iii) the cyclical dynamic outside the United States needs to mature.

We do not presently see these conditions, though we are monitoring them for signs of change. For now, we retain the view that 2018 will be a continuation of the synchronized global growth that we saw in 2017.

The United States is no longer the propeller of the global expansion

Global growth in 2017 was the most synchronized upturn in at least a decade, consistent with a coordinated surge in global trade volumes. All major economies expanded for the first time since 2004–2007, and growth accelerated in two-thirds of these economies.

The cyclical profiles of Europe, Japan and emerging markets look younger and healthier compared with the United States. While U.S. growth should stay on track (just above 2%), most of the heavy lifting should come from secular growth in the tech-related parts of the economy, as well as cyclical growth abroad. We do not see a noticeable growth boost from fiscal policy or tax reform.

Last year’s upshift in global growth may be hard to replicate in 2018, but we anticipate similar growth synchronization. The forecasted 3.6% GDP growth in 2017 and 2018 is a modest improvement from the growth rates seen earlier in the recovery. Next year’s growth is still well below the 5%+ achieved during the period of hyper-globalization in the early 2000s, which was lifted by global outsourcing, China’s industrialization, and the ensuing commodity super cycle. In the absence of these growth tailwinds, the risk of overheating seems limited even as the global expansion broadens and deepens next year.

Thanks to incredibly loose monetary and credit conditions, Europe and Japan have escaped stretches of stagnation

This means above-trend growth can persist for some time. Corporate earnings in Europe only started outperforming expectations in 2016 after a persistent run of disappointing numbers; this should provide a longer runway for positive fundamental support. In Japan, corporate earnings seem to have decoupled from the yen, as earnings estimate revisions recently moved higher despite currency strength. This could indicate that Japanese corporations are no longer dependent on an ever-weakening currency to perform well. In both Europe and Japan, we are encouraged by improving labor market dynamics, with unemployment rates reaching decade, in some cases multi-decade, lows.

This global backdrop is far more constructive than it was a few years ago, when the United States was the world’s lone growth engine.

Emerging markets will continue leading alongside Europe and Japan

China grew rapidly in the early 2000s, and emerging market economies, especially commodity exporters, got an enormous lift. This decade has been far more challenging due to China’s rebalancing away from industrial commodity–intensive growth. The good news is that the commodity-driven imbalances in EMs have largely corrected, and weaker EM currencies have restored trade competitiveness. EM inflation and policy rates have been broadly declining, and growth is now helped by better domestic demand. We do not expect a sudden slowdown in growth in China to threaten the global economy. Instead, we anticipate the strength in consumer demand and global manufacturing to further offset the ongoing deceleration in fixed investment. This global backdrop is far more constructive than it was a few years ago, when the United States was the world’s lone growth engine.

Yields may drift higher, but still along a very shallow rate cycle

Low unemployment, easier financial conditions and a modest inflation rebound should allow the Federal Reserve, under the leadership of its expected new Chair Jerome Powell, to hike policy rates three times in 2018. We continue to see little risk of a much faster policy rate normalization. We expect the 10-year Treasury yield will inch higher next year, but we doubt it will peak much above 3% in this cycle. Despite the Fed’s willingness to normalize its balance sheet, bond investors are justifiably more focused on the longer-term secular decline in both trend growth and inflation.

In Europe, it will likely take even more years for inflation, and therefore interest rates, to normalize. Nevertheless, as the European recovery gains traction, policymakers may become more uncomfortable with the extreme level of policy accommodation.

We expect the European Central Bank (ECB) to finish its bond-buying program in late 2018 before it turns its attention to its first rate hike (we see this as a 2019 story). While the impact on European bond yields will likely be gradual and moderate, this should be enough to support a slow appreciation of the euro. However, Japan’s monetary policy will likely remain incredibly accommodative for years to come in order to reverse long-lived deflationary forces. The Bank of Japan (BoJ) should therefore maintain strict control of the yield curve, exerting a moderate depreciation bias for the yen.

Disrupting the status quo

While the risk of a broad-market recession is low, risks are much higher for investors with concentrated positions in disrupted companies. A look back on the damage Amazon has inflicted over the past several years supports this view: While the value of the overall retail sector keeps rising in line with a robust U.S. labor market, disrupted companies have been penalized to a meaningful extent. Disruption is likely to expand in several directions:

Brands

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Transportation and energy

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Healthcare

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The higher current valuations rise, the lower we should expect future returns to be.

Continued low global yields are supportive for risk assets

Valuations across equities and credit seem elevated. To this we say, “blame it on the yield environment.” Rates are rising along a very shallow global yield cycle, which means that the cost of cash—short- and long-term—will remain low for some time. In many ways, elevated valuations are a byproduct of low cash yields. We think that equity valuations outside the United States look more desirable and, given a stable macro backdrop, should attract the marginal dollar of portfolio investment. That said, it is important that we do not develop a false sense of security, as high valuations do have consequences. The higher current valuations rise, the lower we should expect future returns to be. That isn’t a bearish statement, but a recognition that asset prices will find it increasingly difficult to rally faster than the overall pace of economic growth.

Final thoughts

In our view, the synchronized global growth experienced in 2017 is likely to continue into 2018. That said, growth momentum is shifting away from the United States for the first time during this economic cycle. Low inflation and, by extension, historically low interest rates should support global valuations, but overall returns should be more muted than in 2017. Our base case does not come without risks (see Risks to our view, below), but we believe the global cycle has enough stamina to continue marching ahead. Yet again, we expect 2018 to be a year where “going to cash” underperforms.

Risks to our view

Valuations

We do not see valuations as a near-term market impediment, but we do need to consider the downside. The biggest impact of today’s valuations would be strongly felt if we move from the current positive fundamental backdrop to one that is more negative. If we transition to a recessionary environment, there is substantial valuation downside to equities, and we would position our portfolios very differently.

Geopolitics

This is a challenging landscape. There is elevated potential for international policy conflict. This includes ongoing Brexit negotiations, the potential restructuring of the North American Free Trade Agreement (NAFTA), and tensions between the United States and North Korea, and, more broadly, the South China Sea. To date, we believe markets have appropriately discounted these risks, as their economic impact looks modest, but we must recognize the potential for that to change quickly if unexpected altercations arise. Beyond these already established risks, we are also closely watching the upcoming Italian general election and next fall’s U.S. mid-term elections.

Central bank policy error

Thus far, central banks have been, for the most part, successful in navigating their unconventional policies with the help of a low inflationary environment. Should the inflation environment be much hotter than we expect, a disorderly unwind of central bank policies could ripple through markets.

China

We expect China to continue experiencing low growth relative to its mid-2000s’ boom, but it should not experience a recession or crisis. However, repercussions from a disorderly decline in the currency, concerns about the sustainability of foreign exchange reserve levels, or stress in the banking system, would likely extend beyond emerging markets and affect market sentiment and economic activity more broadly.

Buildup of nonfinancial corporate debt

The 2008 financial crisis resulted from an unsustainable buildup of financial and household debt. These two sectors have deleveraged impressively over the past decade. But it looks now as though the “debt baton” was passed to the nonfinancial corporate sector. Debt-to-cash flow measures are at all-time highs for many companies. We’re comfortable for now because although debt has risen, interest expense burdens haven’t risen as much, and many companies have extended maturities. Nevertheless, if we had to pick a candidate for the cause of the next recession, it would likely be here, although we believe a default cycle induced by high nonfinancial corporate debt is still years away and would require a much higher interest rate environment.

Biographies

 

Michael Vaknin

Michael Vaknin

Chief Markets Economist
J.P. Morgan Private Bank

Evan Grace

Evan Grace

Senior Portfolio Manager
EMEA and Asia Portfolio Management Team
J.P. Morgan Private Bank

Joe Seydl

Joe Seydl

Capital Markets Economist
J.P. Morgan Private Bank

Jeff D. Greenberg

Jeff D. Greenberg

Capital Markets Economist
J.P. Morgan Private Bank

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