Equity markets have edged to new highs, with investors reacting positively as central banks moved to unwind stimulus and hinted at higher interest rates, suggesting a return to a more normal economic environment.
Markets also cheered Donald Trump’s proposals to cut US corporate tax from 35% to 20% in the hope that it would improve corporate profitability. However, failure to secure the repeal of Obamacare reveals divisions in the Republican administration. This means that tax reform is not a foregone conclusion. Given the likely adverse effect on the US budget deficit, the tax proposals are unlikely to be passed in the current format.
Bond yields moved higher, although the yield curve in the US continued to flatten as long dated interest rates moved up less than shorter dated rates. This indicates that investors remain unconvinced about the longer term outlook for rate hikes and the prospects for growth. Sterling has been volatile. Despite the first rate hike by the Bank of England in ten years, the long term outlook remains uncertain. The UK has made little progress with the Brexit negotiations and now questions have arisen over the future leadership of the Conservative party. The recent fall in the pound has boosted blue chips within the UK market and highlights the importance of international diversification.
Economic indicators suggest that we are now at the late expansion stage in the economic cycle in the US and UK. With confidence and employment high, central banks look poised to restrict the growth of money supply.
Following small increases in interest rates, there are already indications that credit growth is starting to slow down in the US. Total bank loan growth has fallen to 3.4% year on year in September, down from 7.9% a year ago.
In the UK, there has been a modest slowdown in the rate of unsecured credit growth, a factor which has been supporting output given the importance of consumption within GDP. The second quarter saw a surprise increase in the savings ratio from a generational low, suggesting that consumers are becoming more cautious in the face of economic uncertainty. Consumer price inflation unexpectedly picked up in September to 3.0%. However, it would appear that the majority of this is not domestically generated. Much of it relates to the unwinding of currency hedges on food and clothing, a factor reinforced by recent sales data from the British Retail Consortium. Pipeline inflation remains low, indicating that expectations for consumer price inflation do not look sustainable. We note the recent rise in oil, following domestic refining cuts in the US due to the hurricane season. Any further sustained increases may change the inflationary outlook.
We discuss in greater detail the breakdown of GDP on page 7 and analyse the outlook. With growth slowing in the US and the UK, investors need to look further afield. Despite elevated political concerns, following the inconclusive German election and the independence vote in Catalonia, Europe looks like it has further to run with potential for more growth in employment. This in turn will help boost GDP. It is also probable that growth in Japan will exceed that of the UK this year. Helped by export growth and improving consumer sentiment, a snap election was called. Following Prime Minister Abe’s landslide victory, we can expect a continuation of the current policies.
Despite the potential for higher interest rates in the short term, we expect only conservative changes. This will help provide support for equities with solid dividends. With inflation currently running above the 2% target, the importance of capital preservation in real terms is paramount. Diversification into the infrastructure sector is looking more viable as premiums to net asset value have narrowed.