Our March 2018 Investment Update discusses the engine of our 2018 investment themes – synchronized global growth and what that means for the markets.
We recently escaped the cold Northeast weather by taking a trip to Universal Studios in Orlando. As huge Harry Potter fans, we enjoyed riding the train from Hogwarts to Hogsmeade. The journey reminded me that while the cars may get all the attention, they would be nothing without a strong engine pulling them.
In my last update, I wrote about our seven themes for 2018. What goes unnoticed, however, is the engine responsible for all of them: global synchronized growth. As long as global economies continue to grow, our key themes should play themselves out as growth is the major driver of each of them. With that in mind, let's take a closer look at what we will be monitoring to ensure the growth engine remains on the track at a pace that is neither too fast nor too slow.
The speed of the engine is critical for global economies. Growing too slowly could lead to a recession. Growing too quickly increases the chance that inflation will rise and the likelihood that the Federal Reserve will snuff out the recovery by raising rates to combat the inflation.
So how will we monitor global synchronized growth? We have been talking for a while about the positive trend in manufacturing activity globally. Readings above 50 represent expansion; readings below that signal contraction. The overall trend in U.S. manufacturing continues to be positive. The Institute for Supply Management's Manufacturing Purchasing Managers' Index (PMI) rose 1.7 points to a new cycle-high of 60.8 in February, the highest since May 2004. New orders, which tend to be a leading indicator of future manufacturing output, have remained above 60 for 10 consecutive months. This trend is not just limited to the U.S — PMIs in most developed countries and emerging markets indicate expansion and are moving higher, as illustrated in Exhibit 1.
As I evaluate the strength of economic data, I like to look forward and often rely on the Conference Board's Leading Economic Indicator (LEI), which forecasts U.S. economic activity for the next six months. A global equivalent is the Organization for Economic Cooperation and Development's (OECD) LEI, which looks at data such as employment, inflation, PMIs and sentiment data for most developed countries around the world. As Exhibit 2 illustrates, there is a direct correlation between this indicator and gross domestic product. This more or less suggests synchronized and healthy growth for the next six months, similar to the last six months.
"Soft" survey data that measures sentiment about the direction of the economy can provide an early indication of future economic strength. Last summer, we noted an unusually large gap between the optimism in soft data such as small business and consumer confidence and the improvement in "hard" data, such as earnings, capital expenditures and commodity prices. Though it took a little longer to become apparent, we may now be seeing signs of an inflection point in the hard data.
Corporate earnings continue to reflect broad-based growth, as evidenced by fourth quarter S&P 500 reporting, which is on track to deliver an annual earnings growth rate of 15%, the highest growth rate since the third quarter of 2011. Equally important is the forward guidance many CEOs have provided in light of stronger global growth and lower U.S. tax rates. Optimistic business sentiment about the future and more favorable depreciation rules, which allow for the deduction of the full cost of expenditures at the time of investment, should help support the uptrend in capital expenditures.
The All Commodities Price index has trended higher over the last few months. Demand for commodities signals stronger global growth because commodities such as metals, energy and other raw materials serve as inputs for all manufactured goods, including houses, automobiles and smartphones.
Cyclical sectors are also demonstrating the strength in global growth, outperforming the S&P 500 index over the past one-, three- and six-month periods. Sectors such as financials, consumer discretionary, industrials and information technology are leading the S&P 500 on a three- and six-month basis. Equally impressive is their performance in February — these sectors either declined by less than or in line with the S&P 500 overall.
Investors are increasingly sensitive to the possibility that the global economy could grow too quickly or too slowly. In early February, equity markets around the world corrected as investors worried that an uptick in U.S. wage prices would cause the Fed to raise short-term interest rates more quickly than expected. Concern about potential trade tensions appears to be the next headwind the market will have to grapple with. But for now, we only expect modestly higher inflation allowing the Fed to maintain a measured approach to policy normalization and that trade disputes can get resolved. In our view, hard data — corporate earnings, capital expenditures, commodity prices and cyclical sector performance — is pointing to continued, broad-based growth.
There is growing evidence that economies around the world are chugging along in a synchronized manner. Above-trend growth and subdued inflation in most of the world should allow central banks, with the Fed leading the way, to begin to gradually normalize monetary policy in order to keep growth and the markets from overheating. We will continue to monitor for signals that may foreshadow a disruption in growth, but for now we believe that the engine of global synchronized growth has further to go. This backdrop of strong growth should support a transition to an environment of slightly higher interest rates and inflation. This environment should still support equities moving higher, though possibly with some unexpected stops along the way.
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Director of Investment Strategy, BNY Mellon Wealth Management
Jeff Mortimer is the director of investment strategy for BNY Mellon Wealth Management. In this role, he leads a team that sets capital market expectations and is responsible for making asset allocation recommendations. Jeff has more than 25 years of experience in the financial services industry.View Profile