February 12, 2018

One month into 2018, economic growth is its best in a decade, both in level and of quality, fuelled by business investment, especially in the US.

At the same time, the risk of deflation has diminished, to be replaced by the risk of a jump in inflation in developed and emerging economies alike over the medium term.

Two key factors underlie this shift: first, growth is widely spread and synchronised across the globe; second, President Trump’s tax cuts – the most important US tax policy decision in recent decades – are kicking in just as monetary policy loses momentum.

We have upgraded our forecast for US real GDP growth in 2018 to 3% (from a previous forecast of 2%). We expect global economic expansion of 4% this year. We do not foresee a recession beginning early next year.

We now estimate U.S. core inflation of 1.9% and headline inflation of 2.3% this year. Globally prices should increase by 2.5%.

As a result of the tax cuts, which will be fully implemented this year, 2018 US corporate earnings growth are currently expected to be well in excess of 20%, creating a positive environment for equity returns. Before the tax reform, earnings were estimated to rise only 12% this year.

We expect the positive impact of the tax cuts to wear off as time goes by, although in our central scenario we still expect US GDP to grow by 2.2% in 2019 and corporate earnings to increase by about 10%.

Major central banks are expected to sound uniformly more hawkish this year but, with the exception of more interest rate rises from the Federal Reserve, most should keep policy unchanged throughout 2018.

We now anticipate four 25bp rate hikes from the Fed this year and two in 2019. Any tightening in policy by the European Central Bank is unlikely before the end of 2018 or early 2019 and we expect the Swiss National Bank to follow suit. We expect that the Bank of Japan will maintain intact its programme of quantitative and qualitative easing and its yield curve control policy aimed at capping long-term interest rates.

We believe the growth spurt in the US and our projection of four Fed rate hikes this year (while the ECB and the Bank of Japan remain pat) should put a brake on the US dollar’s decline, allowing it to stabilise around USD1.24/€1.

This year’s benign outlook is not without hazards, with plenty of economic, political and geopolitical risks.

First, the changes highlighted above could cause economic disruption, especially if the Phillips curve begins to follow a more normal pattern: should stronger job creation boost wages and lead to substantially higher inflation, then central banks could find themselves “behind the curve”.

Second, an election win by a party of the extreme left or right in a country of global economic significance could destabilise growth. (However, we rate this risk as low, even in Italy’s parliamentary election on March 4.)

Geopolitical risks are the third risk. Tensions between the United States, China, North Korea and Japan and between countries in the Middle East have so far been confined to leaders’ rhetoric.

However, should verbal spats begin to affect economic decisions, the impact could be negative.

If any of the above risks were to materialise, market volatility would pick up, stock and corporate bond prices would fall and sovereign bonds would move higher. Current high stock market valuations leave no room for disappointment over economic growth or earnings.

Asset allocation 

We are bullish on both DM and EM equities, which will benefit from stronger and higher-quality economic growth. We now expect total returns of around 16% in the US and 12% in Europe this year. 

With higher long-term interest rates reflecting inflation pressures, we are bearish on sovereign bonds, although we continue to see them as a safe-haven asset and diversification tool in case of a shock. We have raised our target for the yield on 10-year US Treasuries to 3% by the end of this year from a previous 2.6%.

We have changed our stance on high-yield bonds from bearish to neutral as spread compression continues to compensate for the rise in long-term rates seen since the beginning of the year.