Notwithstanding the slower than expected normalization of U.S. monetary policy, the United States economy is in the best shape as compared to other developed and emerging markets as we enter 2017.
The Bank of Japan is continuing their accommodative stance but may be running up against the limits of monetary policy.
Europe continues to struggle with a host of challenges, from persistently low inflation to “Brexit” lackluster corporate earnings, and election risks.
China is of particular concern among emerging markets as they are challenged by decelerating GDP growth and capital flight.
Almost exactly one year after the Fed began to normalize rates, the committee announced a second 25 basis point increase in the Fed Funds target rate at the conclusion of the December 2016 FOMC meeting. The normalization of U.S. monetary policy has certainly been slower than expected. Regardless of the Fed’s hesitance, 10-year Treasury yields staged a significant 100+ basis point back-up in the second half of 2016 towards 2.45 percent as signs of stronger domestic growth, a bottoming in inflation, and the potential for significantly larger Federal budget deficits in the coming years, resulting from an expected Trump administration fiscal stimulus package, all put upward pressure on interest rates. As we move into 2017, we continue to believe that the United States remains the best house in a shifting neighborhood, while other developed and emerging markets remain challenged.
The Bank of Japan (“BOJ”) made multiple adjustments to its accommodative policies in 2016. In the last six months of the year, the BOJ doubled its purchases of exchange traded funds, announced it will calibrate purchases of Japanese government bonds so that 10-year yields remain around zero percent and introduced a modest amount of additional stimulus of roughly $275 billion. In targeting a two percent inflation goal the central bank effectively declared the quantitative easing program has no end date. This goal may prove elusive as, except for a brief period after the Fukushima event, Japan has not has sustained inflation over two percent since the late 1990’s. It has become evident that the BOJ is running up against the limits of monetary policy, as it now owns more than 40 percent of the outstanding Japanese Government bonds. Near term, fiscal stimulus and stronger corporate earnings are likely to provide an offset.
Inflation also remains weak in Europe; however, this is only one of many concerns. Its members are also being forced to deal with the political showdowns of populist politicians and “Brexit” as well as persistently weak corporate earnings. According to European Central Bank President Mario Draghi, the ECB remains “committed to preserving the very substantial degree of monetary [stimulus] which is necessary” to push inflation toward its target. He has also stressed that the quantitative easing programs have been effective in boosting economic activity. It is evident that the programs in place have had an impact but are only starting to reach the desired outcome.
Emerging markets have faced selling pressure since Donald Trump’s presidential election win started to drive U.S. Treasury yields higher. Debt funds saw their largest ever outflows the week after the election, while currencies have fallen on fears of trade protectionism and more talk of the U.S. dollar being primed for a 1980s-style super-spike. Many countries will be forced to find the fragile balance of interest rate policy and inflation/currency stability in 2017 and into 2018. Even with these challenges, one potential benefit of portfolio allocations to emerging markets may be the tail wind of higher oil prices that could benefit resource providers.
China is of particular concern among the emerging markets. Many market participants have long discounted GDP readings from China, in part due to an unsustainable gain in government spending. Nonetheless, the data shows that Chinese officials are trying to do what they can to stimulate economic activity. Producer inflation has reversed its multi-year decline and is now up 5.5 percent on a year over-year basis, while nominal GDP growth in China has declined from about 20 percent to about 3 percent the last five years, which will make it increasingly more difficult for China to announce 6 to 7 percent real GDP prints going forward. China has also started restricting capital outflows and is taking significant steps to support their currency. The latest round of capital controls is intended to stanch the capital outflow, and halt the decline in FX reserves (and the resulting tightening in financial conditions). Foreign exchange reserves in China have fallen more than 25 percent (approximately $1 trillion). However, these moves will almost certainly scare off inbound foreign investment, while prompting worried Chinese to accelerate their capital flight.
Ultimately, the United States has restarted the normalization process, while Europe, Japan, and China are trying to find new ways to provide additional stimulus in a more difficult political world. These actions will likely fuel further strength in the U.S. dollar and a faster turn in inflation outside the U.S. The divergent paths for policy actions and the greater political, economic, and financial market uncertainty outside of the United States are risks today that could create investment opportunities at some point in the future.