Q3 2018

How Much Further Can Global Growth Fly?

2018 Global Investment Outlook – Q3 Views

A number of market headwinds, including trade tensions, rising interest rates and a general fear the long-running US economic expansion may be facing fatigue have cast a shadow over the markets in the first half of the year. Nonetheless, US economic growth managed to hit a four-year high in the second quarter, and the US equity market marched along to what many regard as its longest bull run in post-WWII history. Franklin Templeton’s senior investment leaders weigh in on whether synchronized global growth can continue, why worries about trade wars may be overblown and why opportunities for investors may be more idiosyncratic or divergent moving forward.

Key Takeaways

  • Generally, we expect positive global economic growth to continue for the near-term, led by the United States and supported by continued profit and earnings growth.
  • We believe growth has peaked in Europe and is decelerating, while economic data in Japan continue to look soft. The US economy is benefiting from stimulus measures including a reduction in regulations as well as tax cuts.
  • The case can be made for continued strength in emerging markets on the heels of favorable demographics and technological advancements. While some emerging markets have been experiencing significant challenges, broadly we think many emerging markets should be fundamentally stable and offer opportunity for selective investors.
  • China continues to de-leverage the shadow banking sector which we believe has positive long-term implications. We will probably see more of a US and China tit-for-tat trade dispute, as opposed to a full-out trade war. Our baseline is it probably increases volatility but doesn’t impact fundamentals much.
  • We think market skepticism is healthy as it balances out overexuberance in the market. And what worked in the last decade probably is not necessarily going to work going forward. We think it’s about applying research to find opportunities best suited for growth in the current market conditions.

Contributors

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Is Synchronized Global Growth Coming to an End?

Q: Global growth still seems to be quite synchronized and relatively strong. What do you see as the primary drivers for global growth now?

Since the 2007-2008 global financial crisis (GFC), rising corporate earnings and profit margins have supported the global recovery, although we are monitoring growth momentum as we are seeing more desynchronization throughout the world at this time.

In the United States, monetary policy is becoming less accommodative, but fiscal policy looks set to pick up the slack. We are carefully monitoring inflation and the potential for increased market volatility. Generally, we expect continuation of positive global economic growth led by the United States. We still expect a small uptick in capital spending as the “America First” Trump campaign continues. The increased spending has helped fuel a modest rise in US productivity, which has offset any wage gains and supporting margins. Lastly, the US consumer remains on solid footing given the strong US employment backdrop.

US Corporate Earnings Continue to Grow
Year-Over-Year US Corporate Earnings-Per-Share (EPS) Growth (%)
As of August 31, 2018.

Legend Key Next 12 months, year-over-year EPS growth Legend Key  Last 12 months, year-over-year EPS growth
Source: Franklin Templeton Capital Market Insights Group, S&P, Dow Jones, Bloomberg.

Meanwhile, the eurozone growth slump appears to be moderating, according to the most recent leading economic indicators. China continues to de-leverage the shadow banking sector, which we believe has positive long-term implications. Furthermore, China’s leading growth indicators have been stable after a very strong first half of the year. We see some evidence of weakness throughout other emerging markets, but believe most of the volatility stems from idiosyncratic shocks; we therefore do not foresee a broader emerging-market crisis, or major slowdown in global growth.

I think the United States is going to lead the pack in the growth cycle among developed countries. The other major economies outside of the United States are showing less potential. Growth has peaked in Europe and is decelerating–it’s not a collapse, but it’s decelerating. Arguably, Japan is still kind of soft as well, and some of the major emerging markets have run into some pretty big headwinds, but broadly I think many emerging markets should be fundamentally stable.

The data are very clear on this: in 2017 emerging markets accounted for 59% of global gross domestic product (GDP) growth in US dollar real terms; China alone contributed 27%, while the United States contributed only 16%.1 Admittedly, 2018 may be rather different given the strengthening of the US dollar but the long-term trend is evident.

We’re not only witnessing a shift in the geographic epicenter of GDP growth to the East, but even within emerging markets there has been a transformation in the drivers of growth. For instance, several years ago China overtook the United States and Japan in terms of total patents filed, and this is but one of many indicators of the shift towards innovation, technology and more broadly the “new economy” that is taking place. The much-vaunted demographics of emerging countries are at play too, both in terms of consumer penetration as well as “premiumization,” whereby demand is rising not just for cars, but even luxury brands.

The commodity story has been losing its relevance for a decade. State-owned enterprises digging coal out of the ground, for example, are no longer the only driver of earnings. Today, it’s also private sector e-commerce and gaming giants. While China has led this shift, we see similar trends across the asset class as a whole.

Impact of US Tax Reform

Q: How do you think fiscal stimulus, including recent US tax reform, is affecting the outlook for the United States right now?

I think fiscal stimulus at the margin is a positive. I think the tax reform is probably more significant because that has allowed companies to finally get some clarity and make investment decisions. And I think in terms of growth, the most important has actually been deregulation. Deregulation is really the trigger for investment growth.

We believe fiscal stimulus was one of many factors driving US economic growth, along with steady monetary policy, reduced regulation and a broadly supportive corporate environment. Amid a strong growth environment, the inflation backdrop continues to firm but remains relatively modest. We continue to believe that global forces—such as supply chains, technology, and labor supply—are putting downward pressure on core-goods inflation, which in turn is keeping inflation in check. Monetary policy is able to gradually tighten, which remains supportive for corporate America.

In the US equity market, I would note we’ve seen the biggest earnings impact within companies whose tax rates were cut the most. They tend to be smaller companies and tend to be domestic companies. There has also been some positive movement with regard to capital spending. Changes in the regulatory environment, and more certainty therein, are clearly very stimulative. As such, we have seen a positive outlook going forward within the business community generally.

I think the old US tax law favored importers over exporters, so that has changed. We have a more equal playing field, and also, earnings that are overseas can come back to United States. In addition, we have seen the benefits of tax reform materialize in the form of acquisitions, stock buybacks and more new investments.

Deregulation is an issue that has not received much press. But frankly, it has probably had as much of a positive impact on the corporate sector broadly over the past couple of years as anything else. With respect to US tax reform, it was really all about corporate tax reform and putting US companies on an equal playing field globally. Frankly, prior to that, the United States was just not competitive from a corporate-tax standpoint. Tax reform has been beneficial and these benefits should be sustainable, in our view. And as noted, we have seen early signs of growing corporate investment and capital expenditures, and that’s something we think will likely sustain itself as well in coming quarters.

Monetary Policy Around the World

Q: Let’s spend some more time on monetary policy. Where do you see us in the US credit cycle?

Clearly, the United States is pretty far along in the economic cycle. US GDP growth of 4%+2 is likely unsustainable in our view, but even if it normalizes to 2.5% to 3%, that still represents a good pace of growth. US fundamentals appear pretty solid right now. Consumer savings rates look healthy and consumer confidence is near record highs. In our view, the health of the consumer, combined with a solid corporate sector, bodes well for the foreseeable future.

Corporate credit is by and large expensive on a historical basis, but despite that, we think the credit cycle still has legs. We think market fundamentals remain very good. As an investor, if you are doing your due diligence in the corporate arena and staying on top of your credit research, you typically find lead indicators of credit deterioration. We haven’t seen worrisome signs of deterioration yet, so we are bullish on a shorter-term basis. That said, we are clearly aware of the age of the US cycle and watching for initial signs a turn may be coming.

The Federal Reserve (Fed) seems likely to continue raising its benchmark interest rate this year and next but I think the important point to emphasize is that the Fed is moving toward a more neutral rate, which it has communicated as roughly 2.75% - 3%. The neutral rate represents the balance between managing the risk of inflation while not dampening economic growth. But in our view, that’s a pretty healthy place to be. Quite frankly, the US economy has a lot of momentum, so in our view, the Fed should be raising interest rates. It should be getting its benchmark rate back up to neutral so it has some ammunition for the next economic cycle if needed.

The Fed has communicated it will likely have to raise rates up to 3% and possibly beyond to keep the economy from overheating and triggering a raise in inflation. Meanwhile, the market seems to be thinking rates may move up a bit this year and next, but should peak around 2.50% - 2.75%, so there’s a bit of a disconnect in terms of where the peak in rates should be. Ultimately, the Fed’s decisions will be data dependent—so it can change its view—but we think it’s a healthy sign for the Fed to remain on its tightening path for now.

Markets have appeared to place a lot of focus on the speed and extent of rate hikes, but not placed enough attention on balance-sheet unwinding. The Fed’s balance sheet has tremendous implications for asset prices. I think the Fed can anchor front-end rates, but mid-to-longer-term rates have to do with inflation expectations and balance sheet adjustment. It’s difficult to find any new major deflationary dynamics: recent trade disputes are somewhat inflationary, wage pressures are starting to pick up, the United States is at full employment, and economic activity is certainly growing above potential. Overall, diminished bond-buying from the Fed and inflationary pressures should push US Treasury yields higher.

There are pockets of emerging markets that we think have been very responsible.

Michael Hasenstab, Ph.D.,
CIO, Templeton Global Macro

Meanwhile, the European Central Bank (ECB) and Bank of Japan (BOJ) obviously have been very dovish. But there are pockets in emerging markets where we have seen them actually lead the pack from a policy standpoint. And I think that’s a lot of what’s behind currency performance in emerging markets. If a country’s policymakers lead, then there is protection. In Turkey’s case, the theory was that high rates caused inflation, so they kept rates low, which obviously created a problem. But, it’s a lot more variant among other countries—there are pockets of emerging markets we think have been very responsible.

Mexico, for example, has done what a central bank should do—buy insurance. They have hiked rates, so that if and when there is a shock, they have an ability to react. And I think you have seen a few emerging markets, when faced with a shock, pursue responsible monetary policy.

Eurozone’s Trajectory

Q: What do you think is the trajectory right now for the European Union (EU), economically and politically?

Economically, there has been a moderate deterioration in the eurozone. We have seen a pretty big spike in Italian government bond yields over the course of the year, reflective of a very populist and fragmented regime. Populism leads to and is often tied with nationalism and tends to look inward, but the eurozone politically only works if countries are integrated and act as a common community. I think the exact reverse is happening now. As long as economic activity is okay and there are no real big shocks, the political system won’t likely be tested. The question will be when we see the next economic downturn, or if there is a shock in Italy, or some other type of shock, will Europe as a community come together like they did in 2011? Or, will countries decide to sort of shut their borders and turn inward?

In Europe, there is a very big difference between the economies and the equity markets. There are a lot of global companies that have very little domestic exposure—this is what we found in many cases in the United Kingdom, for example. The location where shares of companies are listed and where their economic exposure lies are often quite different.

Italy is also one of our worries, and to some degree, Turkey. Turkey has been the stop for a flood of immigration. There is an agreement between Germany, the EU, and Turkey to stop immigration and if that were to turn bad, I think there could be an increase in immigration problems in Europe again.

We would tend to agree that slow growth seems likely in Europe over the next couple of years. From a fixed-income standpoint we really don’t see tremendous values there, but we are looking at individual situations where there may be some disarray for potential opportunities. Overall, we see the region as being pretty stable, but likely a lower-return environment.

Our Franklin Templeton Multi-Asset Solutions team holds a less-favorable view on Europe than some other regions amid political concerns that remain at play; the far-right movement has increased in both popularity and individual-country impact. Positive economic headlines are slowing in pace, although we note that leading economic indicators (purchasing managers indexes, for example), appear to have stabilized at solid levels. Furthermore, equity valuations appear reasonable to us relative to potential reward.

Regarding fixed income, European government bond valuations appear especially full in our view, where term premiums are the lowest among other government bonds. The ECB’s quantitative easing program is scheduled to end in December and we worry about the potential impact it may have on the corporate bond market. Lastly, some headline risk remains due to Italy’s new government budget proposition.

Trade Tensions: Bark or Bite?

Q: There have been questions about whether we are in the midst of a trade war, and what a trade war even means. What do you make of the current tension in international trade conversations?

I would say it is more of a tit-for-tat trade dispute, as opposed to a full-out trade war. In my view, the real risk would be a full-scale retaliatory trade war between the United States and China. But I still put this at a low probability at this point. So far, every action the United States has made, China has responded pretty much with a measured, equal reaction, so we haven’t seen a huge escalation. The United States has one of the lowest import tariffs in the world. Probably what we are going to see is US tariffs go higher, US goods prices go higher and some of the tariffs in a place like South Korea go lower and their goods prices go lower. There is a risk these things can spiral, but I think we have seen some positive steps, for example, in recent trade negotiations between Mexico and the United States.

Mexico has been affected adversely by US trade disputes, but leaders of the two countries seem to have recently come to an understanding. I think it tells us there is a way through this, by updating treaties instead of just tearing them up. The irony is that most of the terms that are going to be put in the new version of North American Free Trade Agreement (NAFTA) were basically from the Trans-Pacific Partnership (TPP). President Trump had wanted to get rid of the TPP but is now going to accept TPP policies under the terms of NAFTA. I think Mexico is an encouraging case study of how there can be a lot of bluster and then at the end there’s a reasonable solution.

It is noteworthy that the US equity market has by and large looked past the trade-related headlines. I agree we will probably see more of back-and-forth in this regard, but in our view, it doesn’t seem like these issues will have a significant impact on global growth. Our baseline is trade tensions probably increase market volatility but likely won’t impact fundamentals much.

I think there is too much fear around the issue of trade. There are a lot of political issues and even defense issues involved in this—particularly with China. Just to give you an idea how important trade is, trade growth has outpaced GDP growth over the last 20 years or so.3 If one were to examine one factor, trade is the single most important one in driving global GDP growth. Perhaps it is less important in the United States, but if you look at what has driven the amazing growth in emerging markets over the decades, it is trade. Trade has literally pulled more people out from poverty than anything else. So, it is extremely important.

The United States had led the world in trade since World War II and had been willing to have lower tariffs than other countries, but probably it is time to relook at some of the older trade deals. China is one of those countries where, when it was starting to emerge, was the beneficiary of some very favorable trade deals. But China doesn’t need that support in the same way anymore. China has a lot of very big projects that are quite competitive with developed economies.

Ultimately, I think trade reform is probably going to be good for China; it should be more stable. The hope is that we end up with freer and fairer trade. Since US growth has been so strong, the United States is in a position where it can be more forceful right now. But that can change, so from an equity point of view, I would be very careful about overplaying this issue as an investment theme.

The reality is that we have no special insights when it comes to predicting the trade policies of the current US administration, so instead we aim to focus on our area of expertise—the changing dynamics on the ground in emerging markets.

Undoubtedly trade tariffs upon China have come at a challenging time, when its labor-cost advantage is fading. Indeed, China is seeing jobs “offshored” to cheaper locales such as Vietnam, and the country is embarking upon the process of deleveraging. However, China is also investing in the future—mass automation is evident in China, which is by far the world’s largest market for robots. Its world-class infrastructure and integrated supply chains result in considerable cost and logistical advantages.

In the last decade, China has shot past the United States to become a far more important export market for most large emerging economies—not least due to its burgeoning consumer market—and accordingly, trade growth now predominantly comes from intra-emerging-market demand. Rising protectionism in the West may further pivot focus towards regional agreements; indeed, China appears eager to replace US leadership in Asia in this area.

More generally it is also worth emphasizing that emerging economies have become much less dependent on developed markets as a driver of growth; this is in part illustrated by the increased weight of the consumer sectors in many larger markets in which we invest. For the MSCI China Index, 93% of corporate revenues are generated domestically, and only 2% are generated in the United States.4 By contrast, the equivalent for US corporates is 62% generated domestically and 5% from China,5 demonstrating China’s downside exposure to US tariffs is perhaps less than assumed, while means of retaliation may be higher.

Opportunities in Emerging Markets

Q: Can you give us an example of how the trajectory for various emerging market economies differs, and where you are seeing opportunities?

 

Asia is pretty stable by our estimates. Latin America is more of a turnaround story where policies were really bad, and they are now either getting better or trying to get better. There are probably more alpha opportunities in Latin America, in our view.

Africa is really idiosyncratic, country by country, and the variance is quite high. In Central and Eastern Europe, we’re a bit more concerned. Countries that had policies which used to be very credible and orthodox, are now moving 180 degrees in the other direction. We have seen a takeover of the press or the judiciary system in some countries that used to be leaders of market-based democracies. I think this could be a concern, and their linkages with the rest of Europe on certain issues are also a concern.

Look Long-Term Across Emerging Markets (EM) for Opportunities
Total Annualized Returns by EM
As of August 31, 2018.

Source: Franklin Templeton Capital Market Insights Group, MSCI, Morningstar.
Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com.
 

It is probably not the best time to be contrarian in regard to emerging markets overall, in our view. Economies that are having a really difficult time may not have hit their bottom at this point. That said, emerging markets vary. Countries that have been more responsible regarding their economic situations have not fallen as much as the others, and if you look at which emerging markets and economies have performed well, they have been in the countries that have been more responsibly managed.

Argentina and Turkey have been at the forefront of equity-market volatility during 2018, underpinning our very cautious outlook for these markets. However, headlines may over-emphasize their significance; more than 10 companies in the MSCI EM Index are individually larger than the combined country weights of Turkey and Argentina (once the latter is added to the index). So, we do not believe these countries’ travails are representative of the broader emerging-market asset class.

A Healthy Market Skepticism

Q: US equity markets have been hitting new highs, but it seems that many investors are quite concerned about investment opportunities and the global outlook. What do you think investors should be preparing for?

We think it is healthy there is a lot of investor skepticism out there. As soon as you lose that skepticism, that’s when you have to really start worrying, and that’s usually the beginning of the end. Right now, there is a fair amount of skepticism not only in the equity markets, but in risk markets in general. We are now in the 10th year of a growth cycle in the United States, so clearly in the back of our minds we have to acknowledge we are going to be in unchartered waters. But we focus on fundamentals, and US economic fundamentals in the near- and even intermediate-term look pretty good to us. We currently have a pretty positive outlook overall and we think the skepticism we see right now is actually healthy. If you put those together, it should be a pretty good backdrop for financial markets.

I think in the equity markets, particularly in the United States or even globally, you have to be prepared for the risks that are out there. That said, I think it probably is not the best time for investors to completely pull in risk exposure. One might want to be a little bit more conservative perhaps, but I think it is very hard to predict exactly when a pullback or correction in the market will happen. I’m still quite positive on equity markets in general.

We have seen what we consider to be full valuations in certain parts of both the equity and fixed income markets. We have taken the opportunity this presented to us to reduce select holdings and increase holdings in other areas with less perceived risk. We have been more selective about our risk exposures, preferring to focus our investments—taking more targeted and concentrated position sizes—which is consistent with our view of a market offering attractive opportunities, though in less abundance than we have seen in years past. Essentially, our efforts are now focused on shedding asset-class allocation risk for more idiosyncratic risk, with targeted and concentrated exposures to specific investment opportunities.

We have been focusing more on idiosyncratic alpha opportunities and not just getting this broad market beta. I think it’s pretty hard to argue that broad market beta is cheap; in fact, it is probably pretty expensive. The danger with passive investing is that you get a lot of index beta without focusing on the smaller subset of alpha. Certainly, there is risk in those subsets, because it’s more concentrated and it’s idiosyncratic, but we also see the greatest value in those specific selections. I think the other thing investors should look at is uncorrelated assets. When there’s a drop in the equity market, or a drop in the bond market, what happens to your other positions? If they are all moving in the same way when you have a shock, that’s not very effective portfolio construction. And, what worked in the last decade probably is not going to work going forward. So, I think the opportunity is in identifying idiosyncratic, isolated alpha and trying to hedge out the broad market beta.

If you are in the wrong beta, it can be really, really expensive.

Stephen Dover, CFA,
Head of Equities

Michael makes a really interesting point saying that beta is actually expensive right now because there is such a focus on trying to keep beta cheap. However, if you are in the wrong beta, it can be really, really expensive.