Economic hegemony

Economic hegemony

Posted on 1 August 2014

For a long time, those looking to understand the future trajectory of the world’s economy and capital markets have been well-served by looking at data coming out of its largest economy, the US. However, with the Chinese economy now larger on some measures of output, is it time to start looking elsewhere for our economic tea leaves?

Why do we care about the US?

The last few years in particular have rewarded those who tuned-out much of the economic noise around the rest of the world and focused on a few core US indicators such as the ISM and retail sales. The recovery in household net worth – as financial and tangible assets have bounced ($26trn since Q1 2009) – and the resultant surge in consumer spending has proved a much more important story for the world’s economy and capital markets than either Europe’s existential crisis or China’s ongoing economic slowdown in the end.

But this will change eventually. A 2010 study suggested that, at the time of  publication, less than a third of the world’s population could be classified as middle class (defined as daily expenditure between $10 – $100), with around half of this bourgeoisie living in developed countries. By 2030, assuming a continuation of current trends, the authors suggested that over half the world’s projected population could be classified as middle class, with Asia likely accounting for two thirds of this number. While any 20-year projections (even those based on the more reliable foundations of demographic trends) have to be taken with a healthy degree of scepticism, data shows that the US consumer’s dominance is already starting to fade.

This week’s data

In spite of the trends mentioned above, the US, for the moment, remains the best place to look for indications of where the world’s economy and capital markets might go next.

With this in mind, this week has been particularly important. The US ISM manufacturing survey, the longest-running and most-trusted of cyclical lead indicators is, again, telling us that brighter times lie ahead for the US and, therefore, the world economy. A strong ISM survey has been shown to be important for equity markets, both developed and emerging. Certainly the stronger tone of recent business confidence readings is starting to show up more forcefully in US earnings and revenue estimates. This last month has seen forecast US revenues for the quoted corporate sector hit another all-time high. Consensus expectations for revenue growth for the US corporate sector now sit at 3.6% for 2014 and 4.5% for next year, sensibly chiming with consensus forecasts for global GDP growth.

The outlook for private sector demand in the US remains encouraging.  Real disposable income grew close to 4% in the first half of the year, while the employment backdrop continues to improve as evidenced by today’s number. Meanwhile, this week’s first attempt at estimating US Q2 GDP also suggested that the US corporate sector is starting to buy more than just its own stock.

It should be no surprise that we have been starting to see a slightly perkier inflation picture accompanying all of this. We do not necessarily see inflation spiralling out of control in the immediate future, but we can see the US continuing to get back to work over the months ahead and this will likely see wages and inflation start to pick up more meaningfully.

Interest rates

The Federal Reserve is still suggesting that interest rates are unlikely to rise until at least the second half of 2015. However, investors would do well to remember the limitations of central bank guidance, as illustrated so brutally in the UK only months ago. Similarly to the Bank of England, the Federal Reserve could easily be hustled into an earlier rate rise if the economic data continue to point in one direction. It is this scenario that we still think has the most potential to upset capital markets in the short term.

As interest rate rises loom larger, plenty of investors will worry that the US economy – for so long a patient in need of monetary A&E – will struggle to digest tighter monetary policy. Such fears could prompt profit taking and swings in risk appetite. In the last month, we’ve already seen yields on the short-dated US issues creep higher, reflecting the improving tone of the data and an almost imperceptibly less-dovish Federal Reserve. It follows that this last month has also been a less positive one for developed stocks and US high yield credit markets, in particular.

What to do?

As suggested above, we do not see interest rate rises as meaningfully altering the trajectory of the economic recovery just yet; we think both the UK and the US have long been capable of digesting tighter monetary policy. However, we do expect a little returning strife in capital markets as investors grapple with the implications of an end to emergency level monetary policy. In the first instance, this may manifest itself in a reduction in risk appetite hitting equity markets, both developed and emerging, and some of the riskier areas of the credit complex hardest.

However, while we expect equities to bounce back from any weakness relatively rapidly as growth continues, the likely weakness in much of the fixed income space could be more permanent. This is obviously just our view of the most likely of many potential scenarios for the second half of this year. There are many other sources of volatility – geopolitical and economic – that could see investors scurrying for the safety of government bonds or gold in the short term.

Diversification, both at the asset class and sub-asset class level – alongside a steady focus on your investment objectives and time horizon – remains an investor’s best defence against the unknowns of the future. Within this diversified portfolio, we are still urging clients to position themselves for further upside in equity markets and a potentially torrid time for much of the bond complex in the months and years ahead.

The importance of China to the world economy is no doubt rising in line with its rapidly expanding middle class. However, it will probably be many years before we need to think about looking anywhere but the US for clues on where the world’s economy and capital markets are headed. In terms of output (adjusted for purchasing power parity), one US consumer is still worth over five of their Chinese counterparts. And developments this week have provided further evidence that the prospects for the world’s number one customer remain positive.

For investors already appropriately diversified at the asset class and sub asset class level, the best advice remains to sit on your hands and resist the urge to trade. For those yet to diversify, there is still time, but it’s running out.

William Hobbs, Head of Equity Strategy, Europe

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