4th Quarter 2018
Global growth: Overall, global economic growth remains solid but is less broad-based than at the beginning of the year. The upturn in advanced economies is mainly being driven by the USA and its expansionary fiscal policy. Among the emerging economies, oil producers are benefiting from the recovery of energy prices, while countries such as Argentina and Turkey are suffering currency crises. As a result of heighted protectionism, international trade in goods has lost momentum since the beginning of the year. These developments also prompted the International Monetary Fund to downgrade its forecast for this year's global economic growth from 3.9% to 3.7% in early October.
The economic outlook for the coming months remains favourable, as the expansive monetary policy in advanced economies and the improved labour market conditions are supporting the global demand. However, a further slowdown is expected, given that many economies are already growing above potential and risks are rising. Globally trade disputes and the challenges associated with normalising monetary policy pose the greatest risks.
Last year was a very positive one for emerging markets. Economies such as Russia and Brazil saw the end of years of recession, China's growth exceeded expectations, and towards the end of the year there were also signs of a recovery in India after the disrupting demonetisation of the previous year. The stock markets reflected these positive developments. The MSCI Emerging Markets (EM) Index achieved a total return of 37.3 %, outperforming the S&P 500 by 15%. This strong performance and the continued positive economic outlook led to massive capital inflows into EMs. In January, emerging market equity funds recorded net inflows of approximately USD 21 billion, a record high in the last 8 years. Due to the growing uncertainty in Turkey and other EMs, investors withdrew funds of USD 8.5 billion during the summer. Outflows of this magnitude were last seen in 2015, when more than USD 15 billion fled EMs in a month amid the sell-off in China.
Our risk aversion index for emerging markets shows that, compared to earlier episodes, the current turbulence is also increasingly being driven by idiosyncratic factors rather than a general aversion to emerging markets. In other words, investors seem to be differentiating increasingly between emerging markets, and rightly so. We therefore rate the current risk of contagion in other emerging economies or even industrialised countries as limited.
Growth: Swiss economic growth is stronger than originally estimated. In the summer, the Federal Statistical Office revised gross domestic product (GDP) figures upwards for the past three years. For instance, economic growth for 2017 was revised from 1.1% to 1.6%. The latest data for the second quarter signals a GDP expansion of 0.7% compared to the previous quarter, an increase of 3.4% year-on-year. Growth was mainly supported by the recovery in the manufacturing sector. Overall, leading indicators point to continued favourable economic prospects, but a slowdown in momentum is to be expected. The purchasing managers' index (PMI) reached its lowest level since May 2017. This downward trend is corroborated by the Swiss National Bank's (SNB) business cycle index and its surveys. However, the latest data from the KOF Swiss Economic Institute paint a somewhat brighter picture. Overall, the analysts surveyed by Bloomberg expect GDP growth of 2.3% for the current year, which would be the strongest growth since 2014.
Labour market: The labour market is improving steadily as a result of the cyclical upswing. The unemployment rate remained at 2.4% in September, but this represents a significant reduction compared to last year, when 3.0% of the labour force was unemployed. Put differently, this means that there are currently 26,853 fewer people who are looking for a job than year ago.
Inflation: Inflation fell from 1.2% to 1.0% in September. Important drivers of the current inflation trend continue to be energy and food prices. If these products are excluded from the calculation, consumer prices have fluctuated between 0.4% and 0.6% since the start of the year. Inflation is thus still in line with the SNB's definition of price stability. The SNB also does not expect any further significant changes in consumer prices and is forecasting an overall inflation rate of 0.9% at the end of the year.
Growth: Following very strong growth figures last year, growth weakened significantly in the first half of 2018. The decline is mainly due to less dynamic foreign trade. Leading indicators such as the PMI and the European Commission sentiment index, which fell sharply at the beginning of the year, managed to stabilise in the summer months, but recent figures point to a further slowdown in the pace of growth. Despite this slowdown, many economic signals imply above-average growth. Analysts therefore expect GDP growth of 2.0% for 2018, which is 0.4 percentage points less than last year, but still well above the monetary union's long-term trend growth.
Labour market: The labour market continues to brighten. In August, the unemployment rate in the eurozone fell by 0.1 percentage points to 8.1%. This is almost one percentage point lower than in the same month last year and the lowest rate since November 2008. The countries with the lowest unemployment rates in the eurozone are the Czech Republic (2.5%) and Germany and Poland (both 3.4%), while in Spain and Greece between 15% and 19% of the labour force are still looking for a job.
Inflation: The flash estimate for eurozone inflation in September shows a rise of 0.1 percentage points to 2.1%, but core inflation remains significantly lower at 0.9%. Based on this, Bloomberg's consensus forecast for overall inflation in the fourth quarter currently stands at 1.9%, while the European Central Bank (ECB) is assuming a core rate of 1.1% for the year.
Growth: The USA is one of the few advanced economies that experienced an acceleration in GDP growth in the first half of the year. In the second quarter, GDP grew at 4.2% (annualised), the highest rate since 2014. Increased consumer and government spending, as well as solid export growth, provided positive growth contributions. The strong labour market is likely to bolster consumer spending throughout the remainder of the year. Leading indicators such as the PMI and consumer sentiment also point to continued robust growth in the coming months. Bloomberg's consensus forecasts for the year therefore currently stand at 2.9%, 0.7 percentage points above last year's growth rate.
Labour market: In September, the unemployment rate fell to 3.7%, a 49-year low. Although wage inflation fell slightly in September from 2.9% to 2.8%, it is likely to rise in the medium term. As mentioned in our last Market Outlook, other labour market data suggests growth of 3% for the next 3 to 6 months.
Inflation: Inflation, as measured by the PCE deflator, the preferred price measure of the US Federal Reserve, stood at just under 2.2% in August, and 2.0% excluding energy and food prices. Core inflation is thus at the target level set by the Federal Reserve Bank (Fed). Analysts and the Fed expect inflation to fluctuate around the current value up to the end of the year.
Review of Q3: After an interim high at the beginning of August, yields on ten-year government bonds in Switzerland, Germany and the USA fell back to their starting level by mid-August. A trend reversal then began, triggered by strong economic data from the USA, taking these yields to a quarterly high. Yields on 10-year US Treasuries rose 0.44 percentage points from their low point in August to 3.25% up to 9 October 2018, the highest level since 2011. Ten-year government bond yields in Germany and Switzerland experienced a similar movement, but did not reach multi-year highs. The yield on both German and Swiss government bonds rose to 0.56% up to 9 October 2018.
After rising in the first and second quarters, credit spreads on corporate bonds fell in the third quarter by an average of around 20 basis points in the USA, whereas they moved sideways in Europe. Investors were particularly concerned about the political turbulence in Italy. Despite all warnings, the new government decided on a budget deficit of 2.4%, which is likely to lead to a further increase in the currently very high government debt ratio of 131%. As a result, yields on Italian government bonds rose significantly. Consequently, the spread to 10Y risk German government bonds widened to nearly three percentage points - the highest level since 2013.
Outlook: The US Federal Reserve again raised its key interest rate in mid-September to a target range of 2.00% - 2.25% and is projecting a policy rate of 2.375 % for the end of 2018. This means that another rate hike is to be expected by the end of the year. At the end of 2019, the Fed funds rate should then be 3.125%, and at the end of 2020 it should reach a cyclical high of 3.375%. The Fed now estimates a slightly higher long-term equilibrium interest rate of 3.0%. Fed Chairman Jerome Powell prepared the financial market for further interest rate hikes at the start of October, stating that the USA was in “extraordinary times” with low unemployment and low inflation. According to Chairman Powell, the current interest rate level is still accommodative, but it is gradually moving to neutral levels.
The European Central Bank announced that the expectations of financial markets regarding the timing of the first rate hike are currently in line with the Governing Council's statements. Accordingly, it is unlikely to raise the policy rate until the end of September 2019. By defining this very concrete course of monetary policy, the ECB has significantly reduced the uncertainty surrounding future interest rate developments in Europe. A major rise in interest rates is not expected, but the trend towards higher interest rates in the medium term remains intact.
Despite the good economic situation, the Swiss National Bank has opposed a tightening of monetary policy. It considers the value of the Swiss franc still to be too high. It is therefore unlikely that the SNB will tighten its monetary policy before the ECB. As before, the evolution of Swiss interest rates his closely linked to monetary policy in the eurozone.
Review of Q3: In the third quarter, US equities clearly outperformed the global market thanks to very favourable economic prospects and strong earnings growth. The S&P 500 showed strong price gains from July to September, surpassing the highs at the start of the year. Within the S&P 500, stocks in the technology sector led the way, climbing by almost 20% this year. However, uncertainty over trade disputes and turbulence in emerging markets affected stock markets outside the USA. For example, the total return for the first three quarters of the year for the MSCI World Index is just under 4%, well below the 10.6% of the S&P 500. European stocks, measured by the Euro Stoxx 50, yielded a return of -0.6%, and Swiss investors achieved a total return of 0.2% on the SMI.
Outlook: The less dynamic but still robust growth should continue to bolster corporate earnings and thereby equities. US equity markets are also supported by the tax reforms implemented this year. However, rising labour costs on the horizon will increasingly put pressure on margins.
Valuations are currently looking more attractive than at the beginning of the year due to the market correction in February. For the S&P 500, the expected 12-month price-earnings ratio (P/E ratio) was still 18.2 at the beginning of the year and 15.8 mid-October. Similar decreases can be seen in the valuations of the SMI and the Euro Stoxx 50. However, the current figures are still above average, especially for the USA.
The trend towards higher volatility, which we already highlighted in our Market Outlook at the beginning of the year, continued in October. This is not likely to change in the foreseeable future. With a further rate hike in the USA and the end of the asset purchase programme in the Eurozone in the next three months, monetary policy in the USA and Europe will become less expansionary. Furthermore, the US midterm elections and the budget discussions between the Italian government and the European Commission are at the same time also likely to stir up political uncertainty.
Review of Q3: The crises in some of the emerging markets triggered strong capital outflows, leading to heightened demand for safe havens such as the US dollar and the Swiss franc. The US dollar also benefited from rising interest rates and a flourishing economic momentum. This, in contrast to the eurozone where, as already mentioned, economic data was rather disappointing, thus weighing on the euro. At the end of the third quarter, the EUR/USD exchange rate was 1.16, corresponding to a euro depreciation by about 3% against the US dollar this year. There has also been the same level of loss in value of the euro against the Swiss franc.
However, the biggest fluctuations in the past few months have been seen in emerging markets currencies. On average, these have dropped in value by 11%. Economies with structural problems, such as high current account deficits, high inflation rates or high US dollar debt, have suffered the most. As a result, the Argentine peso has depreciated by around 50% and the Turkish lira by around 40% since January.
Outlook: In general, we expect the uncertainty surrounding the economic policy direction of the Italian government to come to an end without further escalation and believe that the trend of negative data surprises for the Eurozone has bottomed out. This, coupled with the ECB taking another step towards normalising its monetary policy at the end of the year, should allow the euro to rise again towards the 1.20 franc mark, which we currently consider to be a fair value.
The future interest rate differential and the robust economic outlook point to a continued strong US dollar. Against the Swiss franc, the greenback is therefore likely to remain overvalued.
If, on the other hand, risk aversion continues to increase, the Swiss franc and the US dollar, as safe havens, could find themselves under even greater upward pressure.
 The risk aversion index is estimated using principal component analysis. This is based on daily returns of emerging market equity indices.
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