Economics and Strategy

Growth Convergence, Policy Divergence

— Sean Darby, Global Head of Equity Strategy

2018 should see the Global Economy in a full synchronized upswing while central bank policies diverge. The 2017 disinflation boom is likely to become more inflationary given the closing of many output gaps (full employment, full capacity) but central bankers are likely to differ in their response. The U.S. is moving towards full normalization (rates and balance sheet) while other central banks will likely prevaricate, worrying about the impact of rate hikes on their exchange rates.

The spectre of deflation is disappearing and being replaced by the ghost of inflation. Disinflation forces remain intact but the lack of investment, an uptick in demand from Emerging Markets and extraordinarily loose monetary policy has meant that output gaps have closed. In turn this is forcing labor rates up and domestic spending up.

Since 2016, global equity markets have been synchronized with multiple expansion as a series of monetary coincidences have occurred. The trade-weighted dollar has fallen alongside a massive collapse in global real interest rates. Indeed, as we have often pointed out, that no sooner had Ms Yellen begun raising rates at the end of 2015, the long end of the U.S. yield curve began to fall. With global CPI remaining tame but PPI moving out of deflation, the global economy (and equity markets) has enjoyed what we have termed a ‘disinflationary boom’.

Companies (capital holders) continue to be the major beneficiaries of disinflation with labor (stakeholders) still unable to capture their share of profits. Wage growth is muted. Similarly, U.S. corporate profits-to-GDP are close to their record highs while capex-to-GDP is at almost all-time lows. The question remains how long the current environment can last and when will profits be recycled into the wider economy.

Companies are enjoying a ‘goldilocks’ backdrop for profits with corporate pricing power growing in line with or faster than CPI and volume of shipments rising. In particular, the base effect for many cyclical companies has been exaggerated by the low base effects in 2015 and 1H16. To date over the cycle, governments have become poorer, households have seen little obvious wage increases while companies have seen cash flows surge. Aside from share buybacks, dividend payments, and some M&A, the benefits of the disinflation boom have been saved by corporates. This has been noted from the U.S. to Japan and from South Korea to China.

Indeed, the current returns generated relative to a unit of risk (the Sharpe ratio) is one of the highest in the past 50 years.

We continue to favor Japan, North Asia and Europe ex-UK. We expect stock and sector rotation within the U.S. to offer the best opportunities for active investors while Emerging Markets ought to see very divergent performance in 2018.