Developed Markets Quarterly Outlook

World Economy: It’s Been Great So Far

Market performance during Q3 (August-October) has again been strong, with the MSCI ACWI total return index up 4.5%, bringing the year-to-date return to an impressive 19.7%. To a large extent, strong market performance mirrored improving economic activity around the world. Indeed, global growth is currently running at an estimated 3.6%, with a full 75% of countries experiencing above-trend growth. A recovery that originally started in the US has become increasingly synchronized as the Eurozone economy gained momentum, Japan recorded its strongest bout of growth in years and even China slowed to a lesser extent than many had feared at the beginning of the year.

Nevertheless, investors appear to be uneasy with the current rally, wondering when and what will end it. It is true that with eight years running, the rally is unusually long and valuations in the US are unusually high, when measured by cyclically-adjusted P/Es. The pivotal role of the technology sector is further unsettling market participants, wary of a repeat of the dotcom bubble. But compared to that earlier period, the current run-up of the tech sector has not been unduly fast. Aside from the high valuations, investors may feel uneasy due to the relative absence of more sizeable portfolio flows into equity markets, and of retail flows in particular. This could be either a sign of a lack of buy-in into the rosy outlook or a sign that the rally has further legs.

To be sure, there is no shortage of risks. On the political front, the picture has not improved significantly, but investors seem to be ignoring the negatives. In the US, President Trump continues to shock and unsettle, while not ratcheting up any legislative achievement. The latest project, the tax reform plan, is already running into difficulties, not least because of Republicans wary of endorsing an increasingly unpopular President. Indeed, President Trump has garnered the lowest popularity rating of any President at this point of his tenure in recent polls. In Europe, Germany faces the difficult task of building a tripartite government coalition, while enthusiasm for President Macron appears to be already cooling in France. Elsewhere, Silvio Berlusconi is threatening a comeback at the Italian elections, the Far Right is on the verge of joining the government in Austria and the Brexit negotiations appear to be heading for a cliff.

On the economic front, there remains the risk of a collapse of NAFTA or of the eruption of trade wars more broadly given the belligerent rhetoric from the US. Similarly, the appointment of Jay Powell to the helm of the Federal Reserve represents a vote for continuity, but also puts an untested non-economist in charge during any future crisis situation. Finally, not least because of China’s delayed slowdown, demand for oil has remained strong, pushing the price up 35% from the June trough, to the highest level in over two years. This, together with rising food prices, could weigh on household purchasing power and could bear the seeds for a future slowdown. Indeed, lower food and energy prices had been an important component of the earlier upswing. but now threaten to reverse. With China’s deceleration also deepening, this will likely combine for lower growth in 2018.

Finally, there is a risk of policy mistake. Central banks are looking to undo their extraordinarily accommodative monetary stance, motivated more by financial stability conditions and the perceived need to carve out future room for policy manoeuvre than an imminent rise in prices. Both policymakers and market participants may have underestimated potential growth for some time, expecting inflation to pick up as unemployment falls. However, workers who were thought to have left the workforce are now returning to work, often on precarious or part-time contracts and exercise downward pressure on wages. Were authorities to tighten policy in response to a labor market shift that was thought to be structural but now turns out to be cyclical, they risk snuffing out the recovery.

Market Strategy

Increased growth synchronization, a maturing US recovery and a shift towards policy normalization, together with some building risks, provide the backdrop for our country allocation:

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