Simmering tensions have risen to the fore recently, ranging from the political deadlock in the US to the conflict involving North Korea. However, market disruptions triggered by political crises have historically proven temporary, while the current cyclical trends keep pointing to a solid global economy. We thus continue to favor growth over income assets.
In this report we present our macro assessment and tactical asset allocation for the next three to six months. The investment decisions mentioned herein concern the multi-asset investment strategies managed by LGT Capital Partners.
Over the past quarter, global economic trends have proven resilient enough to withstand some notable headwinds, including a shift to a more restrictive credit policy in China, a political stalemate in the US, and an elevated level of geopolitical belligerence by and against North Korea. Economic growth has generally picked up (graph 1).
The Eurozone and Sweden, whose small but open economy tends to lead continental Europe, showed extraordinary cyclical strength recently, as we already highlighted in the last LGT Beacon. Since then, we have also seen Japan’s real gross domestic product (GDP) expand at nearly three times its potential in the second quarter. In short, most major economies are now growing near or above potential, without generating much inflation – which provides a good foundation for a sustained expansion of corporate earnings. In addition, forward-looking business surveys (graph 2) have picked up again from already high levels in the developed economies, while they continue to rebound from lower levels in the emerging markets (EM). Thus, while Europe’s recent surge should naturally moderate again going forward, the global outlook certainly remains benign.
Furthermore, with regard to US economic policies, the once high-flying expectations for tax reform and/or an infrastructure investment program have fallen so low in the meantime that virtually any sort of progress would probably constitute a positive surprise for investors. The unexpected compromise on the debt ceiling between the Republican president and the minority Democrats last week seems to confirm this – as the S&P 500 has duly rallied to a new record within a few days. In any case, the US economy is performing rather well – with or without additional policy support from Washington.
More importantly, the major central banks are likely to remain as accommodative as possible, even as some prepare to start shrinking the monetary base, a policy commonly referred to as “balance sheet normalization.” Both the US Federal Reserve and the European Central Bank are nevertheless likely to be disinclined to risk major market upheavals, given widespread concerns about hawkish policy mistakes in the face of below-target inflation rates nearly everywhere.
With respect to the tensions on the Korean peninsula, we believe the situation is not likely to escalate to a point that could derail global economic growth. North Korea’s renewed round of missile and nuclear bomb tests and the corresponding US responses may seem to be taking the long frozen but unresolved conflict to a whole new level. Still, given the power balance and the interests of the parties involved, our base case is that Realpolitik will prevail in the end. But even if a major escalation were to occur against the odds, the most likely outcome would be a swift collapse of the isolated regime in Pyongyang – which would also not have a negative effect on the global economy.
In terms of market impact, a major military confrontation in Korea would of course initially rattle markets. However, the medium-term market response would most likely be comparable to similar shocks in the past, such as US-led coalition wars against Iraq in 1991 and in 2003.
A larger negative economic and market impact would seem possible only if such an escalation in Korea were to lead to a hardening confrontation between the US and China. However, that is a very remote scenario in our view for now.
In any case, the historical record shows that the S&P 500 tended to quickly recover from the initial selloffs triggered by political crises - and traded significantly higher about a year later in most cases (graph 3).
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Note: The next edition of the LGT Beacon is scheduled for 18 October 2017.