The global economy entered 2018 with strong momentum, bolstering hopes of continued positive gains
in financial markets. Then market volatility returned with a vengeance in the first quarter and the U.S. escalated
trade disputes with key partners. Could market turbulence and trade tensions stunt the economic cycle?
|Stay alert to key issues
⊲ Pace of global GDP
⊲ NAFTA renegotiations
⊲ China's "President for life"
⊲ Threats of tariffs
⊲ Active central banks
⊲ U.S. dollar weakness
Global growth stays the course
Growth in global gross domestic product (GDP) in 2017
reached the fastest rate in six years. We expect growth to
accelerate further in 2018.
In the U.S., tax cuts, deregulation and solid economic
fundamentals are likely to boost GDP growth this year.
We believe the tax cuts that took effect this year will add
a few tenths to the growth rate of an economy that already
was improving. We think spending on capital equipment
(capex) will continue to recover on the back of deregulation
and rising business confidence, as well as incentives
included in the tax cut package.
GDP growth in the eurozone improved in 2017, and we
believe will continue to perform well this year. Employment
is recovering and consumer income is beginning to rise
in some countries, which is likely to support consumer
spending. Capex in the eurozone may be helped by the
recovery under way in bank lending and better economic
growth prospects. In addition, we think strong global
demand should help exports.
We believe U.K. GDP growth will improve as the high rate
of inflation there recedes and wages begin to improve. The
negotiations for the U.K.’s exit from the European Union, or
“Brexit” — which is slated for 2019 — continue to progress,
which is providing some clarity for companies about the
next few years.
Emerging market economies continue to benefit from strong
growth in developed markets and low interest rates globally.
China’s Communist Party cleared the way this year for
President Xi Jinping to stay in power indefinitely by
abolishing term limits on the presidency. President Xi thus
has consolidated his power and is focusing on economic
reforms and “quality growth,” — a term he uses to indicate
that economic growth will be more balanced.
GDP growth remains on track
Source: 2017, International Monetary Fund actual data; 2018, Ivy forecast
Steady rise in interest rates
We believe global monetary policy will continue to move away from the ultra-accommodative stance that central banks adopted in response to the global financial crisis.
The U.S. Federal Reserve (Fed) raised interest rates by
25 basis points (bps) in March, moving its target range to 1.50–1.75%. The Fed indicated that it plans to continue raising rates. We believe the Fed will hike rates an additional 50–75 bps this year.
We think the European Central Bank (ECB) will end its Asset Purchase Program later this year, which will set the stage for an interest rate increase there. While the earliest the ECB could hike rates would be the fourth quarter, we believe the first interest rate hike will not be done until the first half of 2019.
Finally, we think the Bank of Japan will continue to trail other central banks in changing current policies, although we believe it could tweak its yield curve targets by either raising the actual yield or adjusting the bond term later this year.
Trade remains key concern
Our biggest concern coming into 2018 was related to global trade. Slow progress in renegotiations on the North American Free Trade Agreement (NAFTA), the recent U.S. announcement of tariffs on steel and aluminum imports, as well as a range of Chinese goods have sparked new fears about potential trade disputes.
At this point, the greatest tension relates to China. President Donald Trump announced tariffs on a number of imports as well as other measures designed to punish China for its routine practice of theft of U.S. intellectual property. In April, China responded with a series of its own proposed tariffs on a wide array of U.S. products, sending shock waves through already skittish markets. Since no tariff has been imposed by either government, it seems to us these actions could be mitigated if China were to take action on its own to protect U.S. intellectual property rights, open itself for foreign investment and reduce its trade surplus with the U.S.
We believe that policymakers will eventually seek compromises on these issues to avoid disrupting the current economic recovery. Despite repeated threats by Trump to kill NAFTA, negotiations to modernize the 25-year-old agreement continue. In addition, the U.S. recently announced that several countries were exempt from the 10% tariffs on aluminum and 25% tariffs steel, including NAFTA partners Canada and Mexico and the European Union. This leaves the door open for other U.S. allies to negotiate with the administration on these imports. However, we believe trade frictions could linger for a while, triggering more turbulence in the markets.
Dollar weakness likely to continue
After sliding 11% in 2017, the value of the U.S. dollar (as measured by the U.S. Dollar Index/DXY) had fallen another
3% by late in first-quarter 2018. Contrary to what we had expected coming into this year, the tax reform legislation that took effect in January has failed to buoy the dollar. Currency volatility spiked in late January and early February, but has
since pulled back to levels seen during the second half of 2017.
Key currencies rallied against the U.S. Dollar during 2017
Source: Bloomberg; change in value of selected currencies vs. U.S. dollar for the period 12/29/2017–03/27/2018
In addition, the recent U.S. announcement of tariffs on steel and aluminum imports and the resulting concerns about the potential for a trade war also have weighed on the dollar. However, if this stress between the U.S. and its major trading partners were to devolve into a full trade war, we believe the dollar would rally versus both developed market and emerging market currencies. We think that move would be likely as global investors seek the relative safety and liquidity of U.S. assets.
Looking forward to the balance of 2018, we still expect the dollar to remain on a downward trend.
U.S. Dollar likely to be under pressure during 2018
||PRIOR 2018 FORECAST
||CURRENT 2018 FORECAST
|U.S. Dollar to Euro
||1.22 – 1.25
||Expect dollar on downward trend
|Yen to U.S. Dollar
||Dollar likely to end lower
|U.S. Dollar to U.K. Pound
||No change in forecast
Source: Ivy Investments forecasts of exchange rates in 2018 for currencies shown.
Key sectors to watch now
While we remain positive on the economy and do not foresee a recession over the next 12 months, we believe that increased volatility is here to stay. We think markets will continue to grapple with the implications of several factors, including stronger growth, rising inflation and trade frictions. However, a bear market in equities does not usually come without an external shock and a trade war could be that factor if we are wrong about the outcome of current talks with trading partners. Here are our thoughts on how key sectors may fair going forward in this more volatile market.
The sector that fueled the markets for much of 2017 also was rocked by the return of higher volatility during the first quarter. During both periods, the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google-parent Alphabet) led the way. While these large-capitalization stocks face growing scrutiny from consumers and legislators on a range of issues — from data security to reaching “too big to fail” status — we believe technology companies remain fundamentally stable based on earnings, strong cash flows and the potential benefit of lower corporate taxes.
While the sector has been subjected to the overall market turbulence, we believe the Tax Cuts and Jobs Act of late 2017 could have an impact on earnings expectation for financial company stocks. The market appears to anticipate a faster pace of interest rate hikes from the Fed, which may bode well for financials when coupled with the perception of a more favorable regulatory environment. Despite loan growth being a relative detractor for the sector, we see opportunity as bank profits stand to improve based on the Fed’s Comprehensive Capital Analysis and Review in June. This annual “stress test” exercise could allow large bank holding companies to raise dividends and repurchase shares, which may add to their investor appeal.
We believe the health care sector remains an attractive defensive investment, driven by stock selection rather than a sector-wide view. Biotechnology and pharmaceutical companies continue to be relatively inexpensive by historical standards as compared to the overall market. Macro factors like accelerating biotechnology innovation and a more proactive environment on drug approvals by the U.S. Food & Drug Administration are balanced by the ongoing political stalemate on drug pricing. One area we are watching closely this year is how the market is taking the initiative to address rising health care costs rather than waiting for Washington’s lead. The sector has seen several high profile mergers and corporate partnerships that propose to simplify the health care system. If these ventures indeed lower costs and improve services for consumers, it could trigger a wave of consolidation within the sector.
Revenue growth for energy companies moved higher throughout the first quarter as oil prices rose toward $60 per barrel and inventory levels continued to gradually decline. Global inventories actually dipped below the five-year average, which could be a major factor on whether the Organization of Petroleum Exporting Countries (OPEC) maintains its production quota agreement. We think OPEC will provide more clarity on this policy when it meets in June. Meanwhile, U.S. capex spending and the rig count are on the rise, accelerating domestic oil production. We expect U.S. supply to increase by at least 1 million barrels per day in 2018. Service costs have begun to increase with the rising level of activity, which is inflating the cost to drill a well. We believe this increase on the cost structure of oil producers should be supportive for oil prices.
Past performance is not a guarantee of future results. Investment return and principal value will fluctuate, and it is possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in the energy sector can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments, and the cost assumed by energy companies in complying with environmental safety regulations. These and other risks are more fully described in a Fund’s prospectus.
The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through April 2018, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.