Equity markets continued their strong run in the second quarter of 2017, thanks to the global economy hitting its stride and registering the fastest level of growth in six years. For the first time since 2011, the U.S. is no longer the only shining star as economic momentum picked up across the globe.
The S&P 500 index gained 3.1% in the second quarter (Q2), boosting its year-to-date return (through June 30 th ) to an impressive 9.3%. This was eclipsed by the MSCI EAFE Index (net), which gained 6.1% in Q2 and ended the first half of the year with a 13.8% year-to-date gain. Emerging markets led the pack though; the MSCI Emerging Market Index (net) rose 6.3% in Q2 and posting a whopping 18.4% gain over the first half of the year.
At the same time, global central banks found more confidence to embark on a path of policy normalization sooner rather than later. However they face a dilemma in that inflation, which is already below their target, is falling across the developed world. This reality manifested itself in yield curve flattening.
As always, we shy away from making forecasts and predictions. However, there are five questions we are asking as the second half of the year gets underway.
1. Can Congress pass a budget, raise the debt ceiling and move on to tax reform?
According to the original timetable set by Congressional leaders at the beginning of the year Congress would be deliberating a tax bill at this point, having finished health care in the spring. However, the Senate is currently mired in deliberation on health care, and procedurally , they cannot move on to taxes until this is done. Also, Congress has to pass a budget for 2018 by the end of September (when the current fiscal year runs ends), which would act as the vehicle for tax legislation. Yet, Republicans have delayed this due to deep differences over whether tax cuts should be allowed to increase the deficit or be offset by new revenue and/or spending cuts. This means any debate of potential tax legislation will not even begin until September, at the earliest.
The month-long Congressional recess in August means that in reality, they have only a few weeks to complete health care, extend the Children’s Health-Care program, continue federal flood insurance, pass a budget that will keep the government funded and allow tax legislation to move ahead, and crucially, raise the debt ceiling. A significant part of the Republican caucus is opposed to raising the debt ceiling and this could complicate matters further.
2. Will the U.S. impose new tariffs on foreign-made goods, and will trade partners retaliate?
As the rest of the world looks to negotiate free trade agreements, the U.S. is contemplating raising tariffs for a range of goods in bid to boost the domestic manufacturing industry. Unlike any of the other fiscal proposals, which need to go through Congress, the administration has significant flexibility when it comes to trade. They are already using little-known, and little-used , provisions of existing U.S. law for aggressive enforcement and to restrict imports.
The administration is currently assessing whether steel imports from China constitute a national security risk. The problem is China is not even one of the top 10 sources of steel for the U.S. – Canada, Brazil, South Korea and Mexico make up the top four. So potential tariffs will impact U.S. allies more, raising the possibility of widespread retaliation, as opposed to just retaliatory actions from the Chinese. We have written on the ineffectiveness of tariffs that were imposed in the past.
3. How will the Federal Reserve proceed if inflation does not pick up?
At the June FOMC meeting, most members appeared to think that slowing inflation is transitory (and could be attributed to factors such as the sharp slowdown in cellphone plans). However, a few members expressed the worry that slowing inflation would be persistent. Our own investigation suggests that cellphone prices have been falling for several years now, and is not a one-off event. If inflation is indeed slowing, one would think that the Federal Reserve would ease up on its projected rate hike path.
Yet, it was clear from the minutes that participants are also worried about financial stability in the face of low interest rates. This will be a movement away from their primary dual mandates of full employment and stable inflation.
The question is what framework the Federal Reserve will use if it indeed wants to reduce instability from elevated asset prices, without negatively impacting the economy at the same time. Policy makers already depend on unobserved variables such as natural rates of interest and unemployment, and potential output, which sometimes lead to problems when it comes to communicating policy. Including financial stability in the mix, without any clear definition of what this implies, will only raise policy uncertainty.
4. Will the European Central Bank tighten policy if Europe sustains its recovery?
As we wrote earlier, the European recovery continues apace. If this extends well into the fall, and inflation picks up again, the question is whether the ECB jumps the gun and starts to tighten policy sooner than they should, resulting in a policy error (as in 2011). For now, it looks like the ECB is committed to maintaining accommodative policy in the near-term.
Another issue relates to tapering and not in the conventional sense. The ECB may have no choice but to taper as 2018 begins due to a shortage of collateral and it will be interesting to see how they deal with this issue.
5. Has the China risk really eased?
On the face of it, it would appear that the China risk has eased, given that several economic indicators from the country point upward. Also, since early 2016, when there was serious downward pressure on their currency, a few factors have worked in their favor.
The Federal Reserve’s tightening policy has proceeded at a slow pace and the dollar has not appreciated significantly (it has given up all of its post-election gains this year). The Chinese government also instituted stricter capital controls to prevent outflows, reducing pressure on the currency. Crucially, as we wrote in the previous section, Chinese policymakers have also reversed policy and returned to massive lending in an effort to boost growth. As a result, investment has picked up again and this is most noticeable in inventories – China was drawing down its stock of inventories at an annual rate of almost 200 billion yuan in early 2016, but by the end of the second quarter of this year, it was back to accumulating inventories at a rate of 1 trillion yuan. China’s total debt-to-GDP rose above 304 percent in May of this year but the absolute number is not quite the problem. It is the speed at which debt is being raised – return on investment continues to fall and as we wrote more than a year ago, it leaves China with a chronic ailment that requires ever more credit to sustain growth.