Will it Last?

Macro trends have been stable this year in terms of rising growth expectations, declining political uncertainty and EM outperforming developed markets (DM). More recently, inflation expectations and the so-called “Trump trades” have consistently deflated. Will it last?

The widening out of the expansion is in line with our views…
One of our key themes for the year has been that the expansion would continue and widen out to a broader set of countries than at any point since 2010. This is now well underway and we expect it to continue.

…but risks around growth data are moderately to the downside
After a steady stream of positive data surprises, we think the risk is now moderately to the downside. We would expect any moderation to leave global growth above what we saw last year and not derail the expansion. Still, it would be a meaningful shift relative to the stable positive surprises of the first half of the year.

We expect US inflation to slowly firm
While growth expectations have been revised higher, inflation expectations have come down (Exhibit 1), with recent US CPI prints in particular surprising to the downside. We see these prints as a sign of underlying headwinds to inflation, which might take time to unwind. However, we do not think they are changing the medium-term path towards firmer inflation as spare capacity is absorbed. On page 7 we argue that some of the weakness in inflation reflects spill-overs from slack in global labor markets. In the US, Exhibit 2 illustrates that the three episodes we have seen since 2003, when year-over-year (YoY) core CPI has fallen as much as we have just experienced, all have coincided with a rapid slowdown in YoY growth in oil prices. This suggests some contamination into core CPI. Finally, US real wage growth adjusted for productivity has been at its highest since the 1950s in recent years. If some of the real wage gains were unintended and due to unanticipated low inflation, they could have created an overhang on future wage growth. Importantly, these headwinds are all temporary and we think inflation will firm at some point in the second half of the year.

Political risks to remain muted
Political uncertainty has declined strongly in the first half of the year. The French Presidential election result and the declining likelihood of elections in Italy before next year have lowered risks in Europe considerably. In the US, market expectations for growth-friendly policy changes by President Trump have become more realistic as the political and economic constraints have become clearer (Exhibit 3). We expect political risks to be less of a driver of markets in the second half. If anything, we see some upside risks relative to low expectations for growth policies in the US. On the downside, broader geopolitical risks may escalate further such as the situations in North Korea and Qatar.

So, will it last?
From an economic perspective, we think it will, with the second half of the year looking much like the first: a widening expansion leading to tighter labor markets and gradual upward pressures on inflation, with acknowledged uncertainty about when those pressures will start to dominate temporary inflationary headwinds.

The main difference is that both consensus expectations and market prices have reset substantially. This could give rise to large differences in markets. In equities stronger growth and better earnings have been priced, and we see moderate returns from here. We favor a more dynamic approach to dealing with the risk of moderation in growth momentum from lofty levels (page 6). In fixed income inflation risks have been repriced lower. Even though we acknowledge uncertainty about when the turn in inflation will occur, we see the risks as being towards higher rates and higher break-even inflation. Given current expectations, we believe that even a modest turn in actual inflation could have a large market impact. We see a meaningful risk of a fast sell-off in bonds with adjustment to quantitative easing (QE) programs being another possible catalyst (page 8). Finally, we expect EM to continue to outperform DM over the medium term as we outlined in a recent whitepaper. However, the performance is likely to be more bumpy going forward, due to the risks to growth momentum and the risks of a rapid rise in rates.