State of the world

The world economy has reached an unusual state of stability. Almost every country is seeing positive growth – shown as a green square in Chart 1 – but nowhere is growth booming out of control. Inflation is also firmly in ‘goldilocks’ territory.

Goldilocks rules

With the exception of those countries, such as the UK, which have suffered significant currency weakness, inflation is low throughout the world but the number of countries in or close to deflation is low and falling. Inflation, like growth, is neither too hot nor too cold. In addition, there are few financial imbalances within or between the major economies. Geopolitics remains a worry but the immediate economic threats to the world economy are few and far between.

What does this environment mean for investors? Analysis of similar scenarios over the last 50 years suggests that a ‘Goldilocks’ backdrop favors risk-on investing, particularly in equities. Bonds, both government and corporate alike, typically fare less well. However, there are always risks in projecting past performance trends forward.

Currently, the rate of expansion in the U.S. stands at around 2%, but longer term, there’s an argument that secular themes could depress growth to around 1.5%. First, technology-related gains in productivity are moderating. Second, lower birth rates are combining with an aging demographic to reduce the size of the working population.

Regional perspectives

We are now well into the Trump presidency and he has found the process of transferring his pre-election rhetoric into policy reality to be a challenging task. Tax cuts were among his commitments and they remain firmly on the agenda. The likelihood of tax reform has increased in recent months, but if a bill is eventually passed, the size and scope of it may look underwhelming after it has made its way through Congress.

Of course, cutting corporate taxes may have positive economic implications down the road but they don’t fundamentally tackle the challenge faced by a sizable section of the U.S. population – a segment to which Trump owes much of his support. As shown in Chart 3, those who failed to graduate from high school have experienced a significant fall in real incomes over the last decade. The causes of this wage stagnation are numerous – outsourcing due to globalization, technological changes in manufacturing, transition to a services economy, just to name a few – and the solutions are broadly long-term structural changes rather than short-term fixes.

Overall, the U.S. economy is in reasonable shape and inflation remains relatively subdued, particularly as rents – which comprise over a third of the core consumer price index – have stabilized. This, combined with gently rising wages, means that the Federal Reserve is likely to continue to gradually raise interest rates. This is a headwind for markets but for our central scenario, where inflation pressures are moderate, it is more of a gentle breeze than a disruptive gale.

China has its challenges: the trend growth rate is slowing and credit growth is excessive, as we discuss in our central scenario. Yet persistent forecasts of a hard landing have not materialized and China looks set to ‘muddle through’.

Even in a world of synchronized growth, the improvement in Europe’s economies stands out. The reasons behind the upturn are self-evident. The era of fiscal austerity in Europe is over and this, alongside massive monetary expansion, is feeding through into a sustained economic upswing. Italy’s election next spring and key wage negotiations in Germany loom on the horizon but we do not foresee either derailing Europe’s cyclical upturn.

There is, of course, one notable outlier in Europe – and that’s the UK. Negotiations around its withdrawal from the European Union (EU) are proving difficult and whatever the outcome, the country faces a challenging period of readjustment to life outside the single market. More immediately, the pound is still weak but to date it hasn’t done much to enhance the UK’s trading position. It has, however, reduced real incomes and squeezed consumption investment. Ironically, the UK is benefiting from the strength of the eurozone economy and its proximity to it! In fact, without Europe’s recent pick-up, it is likely that the UK would be flirting with recession.

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U.S. version – 11/17

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