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Where Are We Now, Economically Speaking?
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The U.S-Global Economic Relationship
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A Closer Look at Regional Economies
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Expectations for the U.S. Federal Reserve
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Portfolio Implications
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The Prospect of Volatility as the Global Economy Gathers Steam

In mid-2016, our Global Debt team made an out-of-consensus prediction that global economic growth would be improving materially—a prediction that has indeed come to materialize in 2017 and continues to hold this year. Global growth today appears to be in its best shape since the financial crisis of 2008–2009. Unemployment rates are coming down in most of the world, especially in developed economies. Confidence measures are up. And we see increased emphasis on investment, which we believe will promote productivity and growth sustainability.

Since 2016, we’ve witnessed a number of changes—especially in the United States over the last quarter. These changes include fiscal stimulus (the passage of a new tax code and the Bipartisan Budget Act of 2018, which provides additional spending by the Trump administration) and the widening of budget deficits. At the same time, we’re seeing higher wage and inflation figures compared to the last year, along with a marginally more hawkish policy normalization path from the U.S. Federal Reserve (Fed).

The beginning of 2018 saw a kind of “Goldilocks” environment: slow (but steady) economic growth, benign inflation, and an incipient move by the Fed to hike rates. It seems that now, things are gathering steam on all fronts. In our view, the present environment is still benign, since it’s being created for the right reasons. It is also supportive of developed and emerging markets alike. But we could witness bouts of volatility in the markets, such as in response to increases in the U.S. interest rate, or as the U.S. budget deficit expands.

The U.S.-Global Economic Relationship

We view the United States at a more mature stage of the economic cycle than the rest of the world. Presumably, this means the global economy could continue to sustain its momentum even as the United States begins to slow down. Yet the world is interdependent—and a slowdown in a major economy (whether that of the United States, or of, for example, China) could have a global effect. Additionally, the mature stage of the U.S. economy doesn’t necessarily portent the end of its growth trajectory anytime soon.

The Differentiation between Major Regional Economies

China: We expect China’s economy to decelerate mildly in the second half of this year, though we still expect it to grow at a rate of about 6.5% annually—a robust clip by global standards. This deceleration is likely to be driven by a financial-deleveraging policy that China is pursuing (including tighter monetary policy and a stronger regulatory framework) as a result of its debt, which had soared to excessive levels after the financial crisis of 2008–2009. Yet we do not expect China’s modest deceleration to be disruptive to the global economy.

Europe: We believe economic growth in Europe will continue to exceed expectations, or at least maintain its current momentum. In our view, the European Central Bank (ECB) will end its quantitative-easing (QE) measures by the end of this year. Yet we expect monetary policy to remain loose even after the end of QE, and that interest rates (which are currently negative) will remain low for a very long time.

Japan: In Japan we’re witnessing full employment and even labor shortages that are leading to capacity constraints. However, two decades of deflation continue to exact their toll, suppressing wage expectations and price-setting behavior. It’s very difficult to alter such a trend, though we do expect longer-term progress toward the normalization of wages and prices. Such a change could prompt the Bank of Japan to alter its monetary stance of controlling the flat yield curve.

Brazil: We see a benign economic environment in Brazil amid its recovery. Growth has finally turned a corner and is beginning to pick up. Inflation—at least by Brazilian standards—is relatively low, so much so that the country’s central bank was able to ease monetary policy significantly last year. We do not expect the central bank to cut rates much further at this stage, though real rates are still fairly high. Finally, we foresee a difficult election period in Brazil, mainly because there are no established candidates yet. But in our view, all candidates—regardless of political affiliation—are aware of Brazil’s need of economic reform.

Mexico: The central bank of Mexico is the only one in the region that has been bucking the trend of monetary easing, and its interest rate is currently high. The interest-rate differential between Mexico and its northern neighbor is consequential given Mexico’s economic link to the United States. Yet despite this fact, we believe it’s still possible that Mexico’s central bank may hike rates further because of the risk of inflationary pressure via the exchange rate of the Mexican peso.

South Africa: Following a period of political uncertainty and a deterioration in its economic conditions, we are beginning to see a light at the end of the tunnel for South Africa in the wake of President Zuma’s departure and the transition to new leadership. In our view, the country’s challenges—low growth, high unemployment, and pervasive inequality—aren’t going to disappear just because of this leadership change. They warrant substantial structural reforms, which may not take place until after this pre-election year. Still, our outlook for South Africa has improved on the heels of political change and its recent fiscal policy announcement, which may prove economically supportive.

Expectations for the Fed

We expect the Fed to continue on its path of monetary tightening—perhaps as far as three or four additional interest-rate hikes this year. It is our view that the Fed wants to move away from the “zero bound” and normalize interest rates at this mature stage of the economy, where unemployment is low and possibly heading lower, and where inflation is beginning to rear its head. At the same time, we do not believe the Fed is in a rush to hike rates aggressively. It remains to be seen whether the Fed will alter its policy under the new chairman, Jerome Powell, but we will be able to detect such a change by the tone of its announcements in the near future. Given strong data and the fiscal stimulus, the Fed can signal a slightly more hawkish stance by changing its dot plot for 2019.

Portfolio Implications

Despite ongoing changes and the elevated risk we see of volatility, the aggregate picture for us hasn’t changed: Global growth is robust—and likely to remain so. The mantle of that growth has been moving away from the United States and taken up by other countries. The new U.S. tax code may provide an additional boost for some time, but we believe that ultimately, growth will continue to shift to other countries.

As a result, we are increasing our foreign-exchange exposure in expectation of returns (and despite the Fed’s monetary tightening, which may not necessarily cause the dollar to strengthen). Additionally, we do not expect much return from capital appreciation in credit going forward. But we do expect a reasonable portion of potential returns in the portfolio to come from the income we generate.