Reflections on Growing Economies and Fading Stimulus

2018 Global Investment Outlook

Global Fixed Income: Moving Beyond Short-Term DistractionsDec 1, 2017

2018 OUTLOOK: “Upside risk to interest rates remains amid reasonably strong global economic growth, but central banks appear likely to retain their hold on global fixed income markets.”

Calling the direction of global fixed income markets in 2018 presents a challenge. On the one hand, with the global economy growing at its quickest pace for several years, diminishing excess capacity within the leading economies should increase demand for capital and therefore push up interest rates. Yet, as the past few years have shown, predictions of rising rates have consistently proved premature, mainly due to a general absence of inflationary pressures, resulting in a dovish tilt to monetary policy among the main central banks. Investors’ perceptions about the intentions of these central banks, rather than economic fundamentals, are likely to remain the central driver of fixed income markets.

Nevertheless, while acknowledging that a secular upward shift in interest rates has so far proven elusive, we maintain our belief that rates have greater potential to rise than to fall. In many countries, policy interest rates have remained relatively close to historic lows, and the extension of duration that has occurred in global fixed income markets since the widespread adoption of quantitative easing by leading central banks has significantly increased interest-rate risk.

Balance of Economic Conditions Could Limit Significant US and European Monetary Policy Changes in 2018

Looking across the global economy, the outlook for growth appears broadly positive, with the major economies all set to continue their expansion. Except in Japan, the threat of deflation now seems remote, even if long-term structural economic shifts—in demographics and global competition—may well keep inflation stubbornly low. In the United States, growth seems likely to remain steady if moderate, underpinned by robust consumer spending and business investment. Jerome Powell’s nomination to be the incoming chair of the US Federal Reserve (Fed) has provided some re-assurance that the framework of US monetary policy is unlikely to change significantly in 2018, although as several other key positions at the Fed remain open, the current tone of policymaking may still evolve in the coming year.

The eurozone economy also looks in good shape, the best since the global financial crisis a decade ago, and we think this progress should be maintained. But with little sign of any pickup in inflation, the European Central Bank remains committed to significant levels of quantitative easing until at least September 2018, so its dovish stance could limit the scope for European bond yields to rise. However, political developments—for example, an impasse in the Brexit negotiations—may increase volatility in markets, and investors should be ready to take advantage of such opportunities.

Short-Term Uncertainties May Distract from Longer-Term Trends

US fiscal policy appears the area of greatest uncertainty, as the Trump administration and congressional Republicans continue their efforts to pass a tax reform package that includes lower corporate tax rates and the repatriation of overseas profits. If combined with a softer approach from US regulators, a substantive fiscal package could boost US growth, making investors across the world re-assess their views on inflation and monetary policy, similar to the change in sentiment among market participants seen in the aftermath of the 2016 US election. But the prospect of agreement on such legislation remains some way off, in our view, and may well prove too difficult to achieve.

Geopolitics appears likely to cause periodic upsurges in market volatility during 2018, with the Korean peninsula a particular area of focus. While closely monitoring developments, our general view is that it is next to impossible to price in a worst-case scenario in these situations, and bond investors would do better to look to longer-term patterns—for example, the evident dissatisfaction among voters in many countries with the political status quo. At its root may be the widespread stagnation in wages over the last decade, even though unemployment has fallen sharply during the same period. Such populist sentiment could heighten pressure on governments to respond by increasing public spending. How much these demands for a fiscal response can gain traction is likely to shape, in particular, the markets for securities like US Treasuries and German Bunds that have traditionally been viewed as potentially providing the safest havens for investors. It would also affect the calculations of the leading central banks, as they look to further unwind the extraordinary measures undertaken to offset the effects of the global financial crisis.

Growth Picking Up but Inflationary Pressures Have Thus Far Been Limited

GDP Growth in Advanced Economies, Inflation in the United States and Eurozone
Advanced Economies GDP, 2016 and 2017 (Forecast)
US Consumer Price Index and Eurozone Inflation, January 2016–October 2017

Advanced Economies GDP (LHS)

US Consumer Price Index, YOY (RHS)

Eurozone Inflation, YOY (RHS)

Source: International Monetary Fund, World Economic Outlook, October 2017; US Bureau of Labor Statistics, US Department of Labor; Eurostat; as of 11/13/17. There is no assurance that any forecast will be realized. Important data provider notices and terms available at www.franklintempletondatasources.com

ADDITIONAL COMMENTARY

Michael Hasenstab, Ph.D.

Global Macro

Identifying Value in the Post-QE Era

Christopher J. Molumphy, CFA

Fixed Income

Constructive but Cautious for 2018

Ed Perks

Multi-Asset

Optimism and Selectivity in 2018