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It ain’t over till the central banks sing
IN BRIEF
• The macro environment in 2017 provided fertile ground for most asset markets. The recovery strengthened by sector and geography, and while deflation risks receded, inflation failed to accelerate enough to spoil the party. Central banks committed to maintain accommodative policy for the foreseeable future, pleasing equity and bond investors alike. The question on most investors’ minds is: “is this too good to last?”
• We find little cause for imminent concern. The recovery may be “old,” but there is still scope for the expansion to broaden both through Europe and the emerging world. If anything, macroeconomic risks are receding and there is even upside potential if productivity starts to pick up alongside trade and investment. Even in the US, where the cycle is more mature, the leading indicators remain strong and point to robust corporate earnings.
• While the Federal Reserve (Fed) will continue to slowly lift the Fed funds rate higher, longer-term rates are likely to be constrained by ongoing accommodative policy at both the European Central Bank (ECB) and Bank of Japan (BoJ). Do not underestimate the impact of the BoJ’s extraordinary commitment to fix its 10-year government bond yield at 0%. Forget “don’t fight the Fed”; it is the BoJ we will be keeping an eye on.
• Overall, we are more concerned that this “Goldilocks” expansion becomes “too hot,” rather than “too cold,” in 2018. We see little reason to shift out of a portfolio skewed towards risk assets. Given everything seems expensive, we still prefer equities over credit over government bonds. Cash is expected to produce a negative real return for yet another year.
• There are still things to be wary of. In particular, no one knows for sure whether inflation is dead or merely sleeping. Similarly, central banks could get tetchier about whether they are repeating the errors of the 2000s. A punchier uptick in inflation and/or more hawkish central banks would result in significant market moves. To insure against such shifts, investors should think not just about the diversification, but also the liquidity of their portfolio. It might also be worth building positions in assets less vulnerable to inflation and higher yields, such as financials and value sectors over growth. After a period of exceptionally low volatility, a more nimble approach to asset management may well be required this year.
THE RECOVERY MAY BE OLD, BUT IT STILL HAS LEGS
In 2018, the global expansion will be 10 years old. Even for those investors who have fond memories of the 1990s and 2000s expansions, this one is starting to feel a bit long. However, we believe that with growth broadening by sector and geography, the risks of global recession are in fact receding. Most major nations surpassed the forecasts made for them at the start of the year (Exhibit 1).

In the developed world, low unemployment, cheap and abundant credit, and low inflation continue to support moderate consumer spending. What’s more, companies across a multitude of sectors are now more confident about expanding. Based on the latest IMF forecasts, business investment in the developed world not only expanded at the fastest pace in 2017, but also that expansion was synchronised across the G7 for the first time since the Global Financial Crisis. As populist pressures persist in the developed world, governments are feeling under pressure to spend and boost their popularity. Indeed, in recent days, the US administration has made considerable progress towards its ambitions for tax reform, which should support corporate earnings and the take-home pay of lower- and middle-income households. Whether these tax cuts will kick in in 2018 or be delayed until 2019 is yet to be seen. We are also likely to see incrementally more generous policies across Europe. Meanwhile, a pick up in government infrastructure investment is one reason why economic growth in Australia could be higher in 2018. 

On aggregate, the developed world outlook remains robust. Of course, each economy is at a different stage of its economic cycle. The eurozone economy, having double-dipped with the sovereign debt crisis in 2012, is at least two years behind the US cycle. Countries like France, Italy and Spain are still an enormous way off their pre-crisis trend. Ultra-loose monetary policy is still filtering through to the lending rates on the high street, which should help activity recover (Exhibit 3).

Australia is out of sync with the improving drivers of growth in the rest of the developed world. Twenty six years without recession has enabled imbalances to build within the economy which now act as a constraint to growth. Prior drags on the economy, such as the unwinding of the mining investment, are fading but are being replaced by a constrained consumer and world beating levels of household debt.
EMERGING MARKETS ARE BACK ON TRACK
Markets also appear to be marginally more confident in the outlook for China-and rightly so, in our view. During the last few years, much has been made of the risks posed by China’s accumulation of corporate debt. Indeed, some have gone as far as to say Chinese debt is the next subprime crisis in the making. But it is important not to analyse China in the same way as a Western economy. China is a command economy, and the distinction between the government, banks and corporates is often less clear cut. When the Chinese authorities want to expand activity, projects are often conducted by other affiliates, but the final liability still ends with the central government. So when comparing debt in China to other countries, we should consider the total debt (Exhibit 4) to avoid comparing apples and pears.

From an aggregate debt perspective, debt in China is on a par with that of the US and Italy and below that of Japan. Now, remember that China is still at a very early stage of development. Only 56% of its population lives in urban areas, compared to more than 80% in the US and UK. Its potential growth rate should therefore be considerably higher than the developed world during this period of economic convergence. It is also worth pointing out that Chinese borrowing is internally funded by domestic savings and the capital account is still largely closed; there is no external lender to pull the plug, even if there were doubts about repayment, as there were with subprime. Rather than imploding, as some warned at the start of the year, Chinese activity accelerated over the course of the year, so much so that the Chinese authorities have recently tightened policy, which should serve to slow growth slightly in 2018, although it should remain in excess of 6%. Greater confidence in the outlook for China has supported commodity prices, creating upward pressure on the Australian dollar. However, prices are likely to slide as the Chinese economy continues to cool, particularly the housing market, and supply increases when port inventories in China are already high. The recent behaviour of Russia and OPEC has also served to lift oil prices, which will help the emerging world’s commodity exporters. The recovery in global business investment will also support demand for tech exporters in East Asia. Overall, the outlook for emerging markets is looking stronger than it has for a number of years.
THERE ARE STILL UPSIDE RISKS: PRODUCTIVITY COULD PICK UP
While many analysts are focused on indicators that will predict the cycle rolling over, there is one late-cycle upside feature of the recovery that we have not seen yet-a revival in productivity. The absence of productivity growth across much of the developed world has been an ongoing disappointment. Given that stronger productivity essentially enables firms to produce more for less, it is clear why this would provide fuel for roaring markets. It not only helps boost corporate profitability, but also would make central banks more confident that supply is expanding, and, in turn, more relaxed about incipient inflationary pressures. Why be optimistic about this? First, productivity does tend to take a long time to recover after a financial crisis in which the supply side of the economy gets particularly battered. Second, as already discussed, in 2017 both business investment and world trade accelerated, which tends to be associated with stronger productivity (Exhibits 5A & 5B).


POLITICAL RISKS ARE LESS TROUBLING THAN LAST YEAR
This time last year populism threatened the overhaul of the political status quo in a number of countries. The final ballot results turned out to be much less troubling. There are still hurdles ahead, though we do not expect any of them to dominate markets in the way of those in 2017. At the time of writing, Germany was still trying to form a coalition government after the federal election held back in September. If talks fail then new elections look possible in April of 2018. This would leave a vacuum at the top of the eurozone leadership until at least the summer of next year. The Italian elections, which must be held by May, have the potential to create more volatility given support for the anti-establishment parties remains strong. However, we choose to be guided by the experience of 2017 where, at the ballot, voters were persuaded by the economic recovery to stick with the mainstream parties. The key risk for Italy is a fragmented result, which would reduce the chance of major reform. But this is an old story for Italy, with potentially limited concern for markets. The Brexit negotiations may also be reaching a more critical phase. Following the triggering of Article 50 in March 2017, we are now nine months into the two-year official deadline to complete the exit process. The pressure to proceed on this timeline may diminish, however, if both sides agree to a transition arrangement.
That is not to say the discussions will not remain tense. But the EU has been in some sort of apparent crisis for six years, and we should remember what we learned during that time about EU political strategy. There was political blustering and brinkmanship, but solutions were found. The solutions were neither perfect nor definitive; indeed, they often deferred the difficult decisions to further down the road. But ultimately, a way was found to “muddle through.” The EU should feel more confident given the fact the regional economy is recovering and support for the euro is rising.

Australia is not immune to political discord and we cannot rule out another federal election in 2018. The dual citizenship scandal highlights just how thin the current coalition’s majority is. An election so soon after the 2016 election only creates added uncertainty and potentially extinguish the early indications of a pick up in non-mining private business investment. There are always a large number of elections held around the world each year and their impact is often more local than global. Geopolitical tensions are usually present in some form and is another factor that investors must contend with. But the impact of these events is often short-term and not always tied to wide reaching economic ramifications. It’s worth remembering that economics often overrules politics. 
SO WHERE IS INFLATION?
As economic activity marches on, the slack in the economy continues to be eroded. Unemployment is at a 17-year low in the US, and multi decade lows in the UK, Germany and Japan. In Australia, inflation is below the Reserve Bank of Australia’s (RBA) projection. One might have expected workers in these economies to feel emboldened enough to ask for more pay. And yet inflation in the labour and goods markets is nowhere to be seen (Exhibit 7)

The core of all economic theory is that more demand relative to supply creates higher prices. Without this basic foundation, we economists are truly lost at sea! Central banks are puzzling over a number of theories: maybe there is hidden slack in the economy? Maybe globalisation or technological change is keeping prices low? Or maybe, after such a long recession, people have forgotten to ask for more pay each year and inflation has got stuck in the process? The truth is probably some combination of these factors. We do think that globalisation has had a significant structural impact. Outsourcing-or the threat of it-has reduced the bargaining power of developed world workers. When China joined the WTO in 2001, global labour supply effectively doubled. China’s capacity is not yet absorbed, not to mention the potential inclusion of large population countries in Africa and East Asia such as Bangladesh and Nigeria. Given exchange rates are not freely adjusting to absorb the differential in labour costs, the downward impact of globalisation on developed world inflation still has further to run. At the same time, there are more temporary factors that have most likely played a role in lowering US inflation, such as the low oil price and strength of the dollar through 2015. “Hidden unemployment”-the workers that temporarily left the labour market in the depths of the recession-also served to muddy the relationship between headline unemployment and wage growth. As these influences diminish, some pick-up in US inflation seems likely over the course of the year. 
By contrast, underlying inflation in Europe is likely to remain subdued, which will support corporate earnings and encourage loose monetary policy for at least the next couple of years. Growth in Australia remains below potential and the unemployment rate is still far above the pre-crisis level, indicating that there remains plenty of slack in the economy. The shift from part time to full time employment has been an encouraging development over 2017, but the broader measures of labour market health such as underemployment show that there is still significant room for improvement. So, even with the pick up in business and government spending and a labour market that is not ‘tight enough’ means that underlying levels of inflation will languish below the lower end of the RBA’s 2-3% target band. 

NEVER MIND THE FED; IT’S THE BOJ YOU NEED TO WATCH
As central banks toy with the candidate explanations for low inflation, they are in no hurry to normalise monetary policy. This might seem contrary given the Fed is raising rates and 2018 will be the first year it starts to reduce its balance sheet, but the current plan to withdraw stimulus is extremely gradual. By the end of the year, Fed funds is expected to be 100bps from where it is today, but that will still leave it roughly 400bps below the pre-crisis peak. Moreover, we stress it is really important not to just focus on the Fed, but to instead consider the combined monetary behaviour of the Fed, the ECB, the Bank of England and, in particular, the Bank of Japan (Exhibit 9).

The ECB may have announced plans to start reducing its purchases, but it is still planning on adding to its balance sheet through 2018. Moreover, it has promised not to raise rates before it has officially stopped its quantitative easing (QE) programme. Based on its current timetable, that would point to the first rate rise in 2019. The BoJ has never really managed to step meaningfully away from the zero interest bound after its recession in the early 1990s. In its latest effort to stimulate inflation, the BoJ committed to hold the government’s 10-year government bond yield at 0%-whatever the cost to its balance sheet. If expectations of nominal growth rise in Japan and people want to sell Japanese bonds, the BoJ’s purchases force investors to search for yield in other markets. In turn, this supports longer-term government bond prices globally and depresses global fixed income yields. When you combine the commitments made by the major central banks, policy is expected to remain extraordinarily accommodative. Assuming central banks honour the guidance they have given, our base-case scenario is for longer-term yields to grind slightly higher, but to remain very low on a historical basis.
HAS THE BOND CURVE LOST ITS POWER TO PREDICT?
Before thinking about what all this means for portfolios, it is worth dwelling on one further issue with regard to the government bond curve. With longer-term rates remaining low-and Fed funds rising-the US curve is beginning to flatten. This is starting to cause concern amongst investors who have relied on a flattening and then an inverting bond curve to predict a downturn in stock prices. Pre-quantitative easing this was a perfectly logical argument to follow. When long-term rates were anchored at a rate that was broadly consistent with neutral policy (plus a term premium), if the curve flattened it meant policy was no longer stimulative. When the curve inverted, it meant central banks put the brakes on: time to expect a slowdown, if not a recession. If, however, long-term rates are anchored by QE, or even influenced significantly by nominal demand in a completely different region, then this argument could break down entirely. The curve could invert with rates still at an accommodative rate relative to economic fundamentals across maturities. QE has left us in unprecedented times, and we cannot be sure that the yield curve will prove to be the reliable recession indicator that it has in the past. Japan is a case in point. The Japanese yield curve is now almost pancake flat. That has not served to depress lending, activity or the equity market.
IMPLICATIONS FOR MARKETS
Putting all this together, we see no definitive reason to begin shying away from risk assets, certainly not towards government bonds, or cash, which is likely to have a negative real return for the ninth year in a row. And we have to remember we are shopping in an expensive mall. After all, we do not have the option of switching to another asset class that is obviously cheap. The macro fundamentals are the main underpinnings to this view. Even in the US where the economic cycle is more advanced, the lead indicators do not suggest that the economic cycle is about to turn. Consumer confidence, employment and business sentiment all remain robust. And if global productivity begins to rebound alongside world trade and investment, this would fuel the idea that the economy can continue to expand without inflationary-or monetary policy-consequences. And whilst equity price/earnings (P/E) ratios have risen above historical norms, they do not appear overly stretched, particularly in Europe (Exhibit 10). Nor do analysts’ earnings expectations look particularly overoptimistic or out of kilter with fundamentals.

It is also worth remembering that even in the equity markets that do appear a little more stretched, this has not been due to equal gains across the board. The tech sector has done a lot of the heavy lifting in taking the aggregate price index higher. Within equity markets, we are more inclined towards Japanese and continental European stocks, but can’t ignore the potential boost to U.S. markets from the tax reform package. Australian investors may once again find that the local market lags behind the rest of the world in terms of performance. In a world of capital markets where equities are driven by earnings, the earnings upgrades have been much larger offshore. Local investors should also consider the direction of the Australian dollar and the added gains that could come from investing internationally as the currency is expected to depreciate. Even if we are wrong on the fundamentals, we also remain mindful of the fact that we often have more time to shift position than we think. De-risking too early can be more costly than being a little too late when we consider that the final 12 months of past U.S. equity rallies have delivered average returns of 25% vs. drawdowns of 14% in the first six months of things turning sour.
RISKS TO MONITOR
While this all sounds wonderfully benign, we should be prepared to be nimble in 2018. Bear in mind that as 2017 draws to a close, two mammoth questions remain unanswered: is inflation really dead? And will central banks change their minds about how gradually stimulus should be removed? Unemployment is creeping ever lower, and oil prices were up x% year to date at the time of writing. This could lead to a more significant pick-up in inflation. Remember that bond investors are not being compensated for inflation risk in the way that they were pre-crisis, as investors remain primarily concerned about the downside risks: debt, deflation and unconventional policy forcing yields lower. If this balance of risks were to change, the impact on global longer-term yields could catch us out.

We should therefore continue to monitor all inflationary pressures very carefully, including oil prices, wages and core inflation. And keep an eye on nominal growth and the wage rounds in Japan, even if Japanese assets are not directly in your portfolio. In our view, the BoJ is having more of an influence on global bond yields than people are giving it credit for. We will also be poring over the central banks’ communications. Whilst central bank policies have not yet delivered too much goods inflation, they have certainly boosted asset prices. High-profile institutions, like the Bank for International Settlements, are becoming increasingly vocal in warning about the risks of such loose policy on longer-term financial stability. One only has to consider the 1700% rise in the price of Bitcoin over the past year to wonder if they have a point. Central banks are walking the fine balance between a need to stimulate activity and meet their inflation targets and not making all the mistakes of the 2000s boom.
These are the key risks we will be monitoring, on top of well-known concerns such as the potential for conflict with North Korea. While these risks might have a relatively low probability, the market impact could be significant. And so on top of a well-diversified strategy, investors should think about the liquidity of their portfolio: if the tide changes, you will want to be able to shift position quickly. And there are certain trades that will work better in an environment of rising inflation and bond yields. The most obvious would be financials stocks and value stocks over growth. Building towards such a portfolio, one can maintain exposure to the upside as the good times continue to roll, while providing some peace of mind if the story changes. The Market Insights team looks forward to working with you towards a prosperous 2018.

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By J.P.Morgan Asset Management
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