Our global growth forecast is unchanged at 2.5% for 2016 with the principal impact of Brexit being felt in the UK where we have cut our growth forecasts in half for next year. Eurozone forecasts have also been reduced as a result of weaker demand from one of its biggest trading partners and the increase in uncertainty brought about by the referendum result. These effects will feed a broader slowdown in trade and activity in 2017, but the overall global effects are not great given the size of the UK in the world economy.
Global inflation is forecast to rise to 2.2% this year and to 2.5% in 2017. The forecast for next year is partly influenced by the forward profile of oil prices (the oil curve is higher but less steep). Additionally, we feel we will not see significant second round effects from higher inflation into wages, with the experience of recent cycles suggesting that wages have become less responsive to changes in unemployment.
In terms of risks around our baseline forecasts, the balance of probabilities remains skewed towards a weaker growth outcome although less compared to previous
quarter. Meanwhile, with political risks rising, we have introduced a “Trade wars” scenario and a “Brexit shakes Europe” scenario. The former is based on the election of Donald Trump as president of the US, which brings a significant increase in tariffs on imported goods. Ultimately, this scenario is seen as stagflationary given that global trade contracts and global inflation is pushed higher. With regard to “Brexit shakes Europe”, this follows from the UK vote to exit the EU which galvanises anti-EU support across Europe and results in a number of similar referenda across the continent. Our models suggest global growth will be lower than the baseline in such a scenario, with higher inflation in Europe as the GBP and EUR depreciate significantly.
Central Bank Policy
We expect Fed Chair Janet Yellen and company to hike rates in December 2016 to 0.75%, which is followed by another two hikes to 1.25% by end-2017. Meanwhile, we
expect the Bank of England (BoE) to cut interest rates in August as the economy weakens. The European Central Bank (ECB) is also assumed to reduce the deposit
rate to -0.5%, where it stays through 2017. The Bank of Japan (BoJ) is no longer expected to take rates lower following the adverse reaction to their move into negative
territory in January. Fiscal support and the further delay in the consumption tax relieve some of the pressure on the BoJ. However, we do expect them to start experimenting with helicopter money drops towards the end of the forecast period in 2017 in a renewed effort to stimulate growth in a moribund economy. The People’s Bank of China (PBoC) is still expected to cut interest rates and the reserve requirement ratio (RRR) over the forecast period.
Implications for Markets
Looking at our asset class views, we have maintained our neutral bias on equities. Valuations are generally looking fair relative to the risk free rate and even cheap on
some absolute measures. However, our cycle and earnings measures continue to suggest a more cautious view on equities is warranted. We believe that earnings
growth will be subdued this year given the sluggish global growth. Meanwhile, a driver of the deterioration of the global cycle has been a slowdown in manufacturing in areas such as the US and Japan. While the tightening in monetary policy by the Fed has been kinder to risk assets in this cycle, the liquidity backdrop remains vulnerable to higher interest rates. This suggests a more challenging landscape for earnings growth, which is critical for the equity call.
Within equities, we prefer the UK as the FTSE 100 not only benefits from high dividend yields but also a weaker currency supporting multi-nationals. Despite the
high-quality and the low-beta nature of the US market, we have turned neutral. Equity valuations have become richer and have not adequately discounted the potential
uncertainty from the upcoming US elections and the Fed’s continued path of policy normalisation. On Europe ex UK, we have stayed negative largely due to our belief that negative interest rates are likely to be harmful to the profitability of banks and be a headwind to the broader market. In comparison, we have downgraded Japaneseequities as we believe that consensus forecasts for earnings remain too optimistic and fail to make adequate provisions for the strength of the yen on corporate margins. We
have remained neutral on Pacific ex Japan and EM equities. On the latter, we recognise that EM price-earnings multiples have adjusted a long way to reflect a subdued outlook for the global economy. Our forecasts suggest that the growth differential between the EM versus developed market is likely to increase in favour of EM, which should offer support to EM multiples and relative performance.
With regard to the duration views, we have an overall neutral bias on government bonds. Amongst the bond markets, we have retained our neutral view on US
Treasuries but have turned positive on German Bunds. On UK Gilts and Japanese government bonds (JGBs), we remain neutral. We have also maintained our neutral stance on emerging market sovereign debt in USD. Instead, we prefer harvesting the carry in EMD local currency bonds given the attractive real yield.
In terms of the credit markets, we have turned neutral on both US high yield and investment grade bonds. After a period of significant spread tightening, credit is no longer as compelling from a valuation perspective. We believe the US credit sector is in the late cycle phase which means most of the returns will come from carry rather than further yield spread compression. For European credit, ultra-accommodative policy from the ECB should be positive for carry, but valuations appear to be
unattractive at current levels.
We have upgraded commodities given the meaningful reduction in supply particularly in the energy market. Amongst the sectors, we believe longer-term pricing is too
pessimistic on the energy sector as capital spending cuts have been dramatic and we believe that supply and demand will move into balance in the second half of the year.
Meanwhile, we have maintained our neutral view on industrial metals as improvements in sentiment towards the Chinese economy are likely to support prices in the short-term. However, there remains ample supply across most base metals. For agriculture, our base case is that prices are likely to trade sideways given the tug between supply and prospects for adverse weather due to La Niña. On precious metals, specifically gold, we have retained our positive view as US real rates continue to push lower as downside risks to global growth means that the Fed is willing to tolerate higher inflation risks.
Keith Wade, chief economist and strategist at Schroders