Synchronicity has been a key theme for markets in the first half of the year.
Instead of divergence between parts of the world and parts of the economy, almost everywhere is picking up speed at the same time.
This has translated into good returns for equities, especially for emerging markets and the eurozone. Growth forecasts for both regions keep getting revised up, even as expectations for President Donald Trump’s economic policies in the US are being revised down.
One key question for the second half of the year is whether global economic momentum will continue to shift to the eurozone and emerging markets, after years of leadership by the US. We also need to ask if the upbeat mood in markets can withstand slightly less supportive policy from central banks.
There has been a major change in the political weather on both sides of the Channel since the start of the year. Just three months ago, markets were not expecting an election in the UK and political risk in France was still high on investors’ list of concerns.
But by the end of June, Emmanuel Macron had been elected by a very clear margin and his newly formed political party, Republic en Marche, had secured a sizeable majority in the French parliament.
As the President of the European Central Bank Mario Draghi noted recently, “political winds are becoming tailwinds” in the eurozone.
We need to ask if the upbeat mood in markets can withstand slightly less supportive policy from central banks.
Focusing closer to home
The same cannot be said of the UK, where Prime Minister Theresa May’s surprise decision to call a general election appears to have weakened both her own authority and that of the Government, just as it begins formal negotiations for leaving the European Union.
Higher inflation due to the weaker pound is now biting into real wages, which are falling again after nearly three years of positive growth. Consumer confidence has also faltered in recent months, raising the prospect of a more significant economic slowdown in the second half of the year.
UK household spending has held up so far but only with the help of a further decline in personal savings rate, which has dipped to an historic low. What the Bank of England will be watching to see is whether net exports and investment can come to the economy’s rescue. There is mixed evidence on this issue but corporate investment intentions have started to pick up.
Though politics has not gone according to plan, the global economy has not produced any nasty surprises so far in 2017. This marks a nice change from the past few years, when growth forecasts were often revised down in the first half of the year. But investors and economists have been forced, yet again, to reduce forecasts for long-term interest rates – bond yields.
The bond bounceback?
Does this mean the long-awaited turn in bond markets is now on hold? No one can know for sure. We do know that inflation and wages are not rising as fast as expected on either side of the Atlantic, which may, in turn, have slowed the schedule for future rate rises in the US.
There is little in the domestic wage and inflation data to prompt the US central bank to accelerate the path of rate rises. But with most economic indicators looking healthy, there is also, arguably, less need for monetary policy to remain so supportive.
The ECB faces a less extreme version of the same dilemma. It had to nudge down its eurozone inflation forecasts recently. But in a widely noticed speech in mid June, Draghi put more emphasis on the improving state of the region’s economy than the continued low level of inflation. Many in the markets drew from this that the ECB would formally reduce its monthly bond purchases from early 2018.
Draghi has not been the only central banker to make hawkish noises in recent weeks. We have also seen several members of the Bank of England’s Monetary Policy Committee vote for higher rates and heard Fed policymakers raise concerns about the level of US equity markets. This led to small sell-offs in both equity and bond markets in June, leaving markets in an uncertain place heading into the summer.
The news from the global economy has been good. What investors need to decide now is which is more important for asset markets: monetary policy or the underlying state of the recovery?
Stephanie Flanders is chief market strategist for Europe at J.P. Morgan Asset Management