Trump continues to make headlines as polls narrow in the UK. Will the second quarter bring stronger growth for the EU?
Despite a brief bout of politically induced volatility in May, equity markets have continued to drift higher. Markets so far have broadly shrugged off the political risks which have recently shifted from Europe to the US. Continued speculation over Donald Trump’s connections with Russia has raised the possibility of an impeachment, although this looks unlikely in the near-term. Renewed political turmoil in Brazil caused a dramatic sell-off in the country’s equity market and currency following corruption charges against President Michel Temer, less than a year after taking office. Political risks are likely to linger but the main focus for markets remains on the prospects for economic growth. After a weak first quarter, will any economic rebound in the US be strong enough to support equity markets at current record high levels?
US Equity Outlook
While Donald Trump is always generating headlines, market sentiment hinges on when he will deliver his much vaunted fiscal stimulus plan. Optimism that Trump can instigate aggressive tax cuts and increased infrastructure spending is starting to evaporate. A more modest set of measures therefore looks likely, although these could well be pushed out into 2018. While US equity markets remain cautiously optimistic, both the US yield curve and the dollar, two
indicators sensitive to US growth prospects, have fallen back to pre-US election levels. Analysts have yet to upgrade their more forward-looking earnings forecasts, a concern when US equity valuations remain at elevated levels, and sentiment indicators (a contrarian signal) are perhaps showing heightened levels of investor complacency.
The Federal Reserve (Fed) remains confident the first quarter weakness is due to transitory factors and looks set to increase interest rates again in June. Attention has also been on the Fed’s initial plans to begin reducing the size of its $4.5tn balance sheet, accumulated after almost 10 years of asset purchases in response to the Great Financial Crisis. Should this begin later in the year, it is likely to be
an extremely gradual process and good communication from the Fed should avoid a repeat of 2013’s ‘Taper Tantrum’ which saw 10 year treasury yields (which move inversely with prices) spike to over 3%. Given the still uncertain outlook for the US economy and question marks over the fiscal stimulus plans, we expect the Fed to proceed with caution.
Europe and UK Outlook
Now political risks in the eurozone have eased after the election of Emmanuel Macron in France and focus has rotated to the improving economic prospects for the region. More forward-looking indicators point to stronger growth in the second quarter and consensus GDP forecasts (currently at 1.7%) have moved higher. The improving sentiment has seen continued inflows into the region’s equity markets. We remain relatively positive but with heightened expectation comes greater scope for disappointment. Financial conditions have tightened. The euro’s 7.5% appreciation against the dollar since the start of the year could act as a headwind for the region’s internationally exposed companies. A key risk for the eurozone is that the improved sentiment and better data causes a premature tightening of policy by European Central Bank (ECB), a move that could hamper the economic recovery in the region. Inflationary pressures remain weak but focus will be on the ECB’s meeting in June for hints that a change in policy could be on the cards later this year.
The tragic events in Manchester have somewhat overshadowed the UK’s general election campaign but at the time of writing (a week before the election), the polls have narrowed markedly. The Labour Party has continued to gain ground at the expense of the Conservatives, who have seen their predicted majority slashed from 134 seats just a month ago, to around 50 based on current polls. Ultimately once we get through the election, attention will again be back on the direction of travel for Brexit negotiations. Despite the recent war of words between Theresa May and Jean-Claude Juncker (President of the European Commission), we are unlikely to hear anything substantive until after the German elections in September. Sterling is likely to remain the key barometer of Brexit concern and tougher rhetoric from the EU, combined with renewed election uncertainty has meant sterling has faced resistance at 1.30 versus the dollar. The Monetary Policy Committee (MPC) nudged down its 2017 GDP forecast in May’s Inflation Report but is still predicting growth of 1.9%. Given those assumptions are based on a smooth Brexit outcome, we think the risks are skewed to the downside.
After a period out of the spotlight, China has slowly been creeping back onto the radar screen. One of the key drivers behind the reflation trade that began last year was China’s improving growth, fuelled by the authorities’ stimulus measures. Given the high levels of debt and unsustainably high house price inflation, the authorities have already begun to dial down stimulus measures. The squeeze on credit growth could hold back economic improvement in China. Indeed leading indicators for Chinese GDP, including money supply have begun to roll over. On the positive front, capital outflows appear to have eased and the currency has stabilised. We believe Chinese growth could well plateau as the year progresses but the risk of an outright contraction looks slim.