Welcome to "Economic Insights" where you will hear from our experts covering the global economic environment.
So far the two biggest surprises of 2017 are that the 10-year Treasury yield has declined and that global equities have outpaced U.S. equities for the first time in the past eight years. So what is going on and what do we make of it all?
Why Are Interest Rates Staying Stubbornly Low?
Despite two Federal Reserve interest rate hikes so far this year and the Fed saying it will slowly begin selling some of the trillions of dollars in fixed income assets it bought during the quantitative-easing period, the 10-year treasury has actually declined. Bond prices would normally be pressured when the Fed is raising interest rates but that has not happened this year – as a reminder/refresher, bond prices move inversely to yields.
As the U.S. slows its stimulus program, central banks around the world, including the European Central Bank, are also expected to ease off the stimulus accelerator in the next 12 months, in response to a strengthening global economic expansion (more on that in a minute). And yet, Treasury yields are down. Last week, the 10-year treasury actually fell after the rate hike. The yield curve – the spread between yields on the three-month bill and the 10-year bond – has begun to flatten, a sign that economic expansion might be slowing.
This has caught most economists off guard. They expected yields to continue to rise as the vast majority of President Trump’s agenda was viewed as a positive stimulant for the economy. But yields dropped, even as the Fed raised rates. The overarching problem is that the economic data has not been that strong. Inflation is falling, not rising to the Fed’s 2% annual target. Over the past 12 months, the core CPI, which measures the average price of a basket of consumer goods, fell to 1.7% from 1.9% which was below consensus forecasts. Oil prices have also been dropping. The Fed has been saying for two years that inflation will go back to 2% but that just hasn’t happened. There’s also a fair share of geopolitical uncertainty, from terrorist attacks to political battles that have bogged down the Republican plans for tax reform and deregulation. This is setting up a scenario for the Fed to slow down raising rates. We should have more insights into their thinking when the FOMC reconvenes in late July.
What Is Fueling Global Equity Growth?
For much of the eight years that have followed since 2008-09, U.S. equities have considerably outpaced most global equity markets, helped by superior profit growth and the strength of the U.S. dollar. But this year we’ve seen signs of change. An improving global growth environment has supported the outlook for corporate profits around the world and, in turn, equity prices. As we approach mid-year, the change is striking. We see evidence of broad based growth across all regions and a raft of earnings results that affirms our view of a synchronized global recovery. We forecast continued growth for 2017 and 2018. Against this improving backdrop, we see the greatest potential in international equities where valuations are less stretched and profitability gains have further room to run.
And although the U.S. economy is entering the later stages of an economic cycle, we still believe the risk of a recession remains low for now, and therefore we expect another couple of years of solid earnings growth from U.S. corporations. But as we closely watch that scenario play out, we are encouraged by the state of the global economy. And while we do see some potential risks, in particular: overly high equity valuations – especially in the U.S. and other developed nations; a worse than expected slowdown in China; and the expected gradual ending of central bank balance sheet expansion over the next couple of years, there are signs of positive change. It seems for now the global economic improvement that has fueled the international equity markets to levels not seen since in eight-plus years has potential to be a bright spot as we look to the future.
