Slow but Durable Channel Growth Persists at Midyear 2016
What’s coming after trepidations over China and Brexit: concerns over populist politics.
In our opinion at Northern Trust, the markets delivered in the first half of this year. Case in point: A 60-40 portfolio generated a 5 percent–plus return. In the process, investors have faced down worries of a Chinese hard landing and about the U.K.’s recent vote to leave the European Union.
Earlier this year, concerns over the state of China’s economic and financial affairs weighed on market sentiment. Policymakers have responded with easier monetary policy and infrastructure spending, which helped stabilize economic growth. China has also succeeded in significantly slowing the outbound flow of capital, resulting in relative stability for the yuan. Over the long term, China still faces challenges around credit quality and the need to develop a stronger service and value-added manufacturing economy. But the near-term risk of a sharp economic slowdown in China appears to be off the table.
As for Brexit, even though the Conservative Party has moved quickly to name Theresa May as Britain’s new prime minister, the actual negotiation to exit the EU will likely take longer than two years. Markets were quick to differentiate the most vulnerable asset classes — that is, the pound sterling and domestic U.K. stocks — from less affected ones, specifically those from the U.S. and emerging markets.
So, what’s our outlook from here?
We think a slow but durable global economic expansion remains under way. We refer to this as channel growth: not likely to show material acceleration, but not at risk of severe recession either. Even though Brexit could lead to a near-term drop-off in U.K. growth, we see less effect on Europe and likely no noticeable impact on U.S. or Chinese data. The U.S. economy looks to be regaining momentum, with labor markets bouncing back in June, and retail sales handily beating forecasts. Let’s not get too excited, though. A look at the May and June jobs data shows an average gain of about 150,000 jobs per month, well below the monthly average of 220,000 jobs added for the 12 months prior. China economic data are finding a bottom, and the country’s foreign currency reserves unexpectedly increased in June, a further balm to hard-landing concerns.
One of the most significant developments since the June 23 Brexit vote has been the tremendous rally in government bond yields. The U.S. ten-year Treasury fell from 1.75 percent to a low of 1.36 percent, after starting the year at 2.27 percent. Every time the Federal Reserve looks ready to raise rates, the financial markets pull the rug out from under it. We have no reason to think this will change: Lower interest rates for longer remain our core belief. We believe the U.S. ten-year Treasury will remain near 1.5 percent over the next five years.
What does all this mean for investors?
Investors have identified many potential concerns this year. But the right course has been to remain fully invested. Our long-held view is that the global economy is in a durable growth channel. As such, we haven’t been too worried when growth slows to the bottom end of the channel. At the same time, we also don’t get too excited when growth accelerates to the top end of the range. Another leg down in global interest rates has supported equity market valuations. At this point, however, we believe easy monetary policy can act only as a support, rather than a catalyst, for further multiple expansion. Equity markets will be mostly reliant on steady, growing revenues. We remain modestly overweight risk assets, especially those we see as a little less risky, including U.S. equities and high-yield bonds.
The biggest risk to our channel growth outlook is populist politics. We’ll see further tests with the Italian constitutional referendum in October, to reduce the size of the legislature and limit regions’ decision-making powers; and the U.S. presidential election in November, as well as Germany’s and France’s elections in 2017. Recent elections in Spain, Australia and Japan have revealed a bit of a ceiling on the impact of populist politics, though we don’t think we’ve seen the last of this political trend.
Jim McDonald is the chief investment strategist, and Daniel Phillips is a co-manager for the Northern Global Tactical Asset Allocation Fund; both at Northern Trust in Chicago.