Developed Markets Quarterly Outlook

World Economy: The Current Length of the Expansion

The global economy continues to enjoy one of the longest expansions on record, with the US in its ninth year of recovery and the Eurozone economy finally joining the fray with a vigorous uptick. Even the long-languishing Japanese economy has recently shown signs of renewed economic life. Amongst the major advanced economies, only the UK stands out in recording a marked consumption-driven downshift in the face of the uncertainties surrounding Brexit and the poor prospects for the new minority government. While the recovery is shallow, it is longer-lasting in return, in particular as the focus of rising activity shifts around.

Political developments underscore this rotation away from the US. Increasing realism has set in with respect to the ability of the Trump administration to implement its (questionable) campaign promises and deliver the envisaged boost to growth. Grand legislative projects spanning financial deregulation, tax reform or infrastructure spending have had to make way for more piecemeal proposals or got stuck in the legislative pipeline. A more realistic – and less antagonistic – posture towards trade partners such as China and Mexico has also helped prospects for EM in general. Conversely, in Europe, the threat of a populist insurgency following the Brexit vote and Donald Trump’s election in 2016, has been beaten back, for now. Emmanuel Macron won a convincing victory in the French presidential election (followed by a solid win for his newly-created party), while Angela Merkel appears set to win a fourth term in Germany and sideline the nascent AfD party.

The flipside to this positive picture on activity remains the near complete absence of any wage-or inflation pressure. This is true even where unemployment is at decade lows as in the US and Japan and hiring conditions are tightening. Only in the UK is there evidence of rising inflation, primarily as a consequence of the sharp weakening of Sterling. The silver lining is that this economic backdrop creates a conducive environment for risk assets.

Against this backdrop, the US Federal Reserve has delivered two widely expected interest rate hikes this year and released plans for the reduction of its bloated balance sheet. The European Central Bank (ECB) has already begun to taper its monthly purchases and market expectations have been building for further cutbacks in 2018. This view was reinforced by statements of President Draghi that the ECB was increasingly facing a reflation rather than a deflation problem. Elsewhere, the Bank of Canada began to hike rates in July, while the Norges Bank and the Bank of England adopted increasingly hawkish rhetoric, albeit without following through so far (only the Riksbank and the Bank of Japan remain decidedly dovish).

Market Strategy

Barring a major tail risk materialising - such as the breakout of hostilities with North Korea or a financial crisis in China - there appears to be little on the horizon to threaten the sustainability of the current expansion other than the mere passage of time, which raises the statistical risk of a recession. But that is too little to go on without a fundamental catalyst. As a result, changes in our allocation are driven more by changes in valuations than in fundamentals.

We previously upgraded our Eurozone exposure and we remain overweight. On the other hand, we take our downgrades to the US now further and, after having reduced the overweight successively, we think the time has come to reduce it to neutral. The Japanese market has been perennially cheap, but the time seldom seems right to bet on its outperformance. However, fundamentals have begun to change. Despite PM Abe’s political travails, the economy has gathered steam and now appears on the cusp of its strongest expansion in a decade. While inflation remains absent and the Bank of Japan once again pushed back its inflation target, the building momentum warrants an upgrade from underweight to neutral. We also upgrade Canada to overweight as the recovery proceeds and valuations are attractive.

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