3rd-4th Quarter 2017
Content: Switzerland, Eurozone, USA, Focus topic: Central banks begin to withdraw some liquidity
Global growth has firmed and remains broad-based. Favourable financial conditions have strengthened domestic demand in developed markets. Meanwhile emerging markets such as Brazil and Russia have finally come out of recession. The positive momentum is set to continue in the coming months, based on the current global purchaser managers index (PMI). With an expected GDP growth of 3.4% this year, global growth would reach its thirty year average again.
GDP expanded by 0.4% year-on-year in the second quarter of 2017. As in the previous quarter, the data failed to match analysts’ expectations. For many months now, leading indicators such as the PMI and the KOF Economic Barometer have been pointing to strong growth dynamics, yet GDP data falls short. Data revisions and statistical effects partly explain the mismatch. Overall however, only moderate growth is to be expected. The labour market lacks dynamism and the unemployment rate remains at 3.2%. Consumer prices have strengthened, however, after the summer lull. Core inflation rose steadily and reached 0.4%, the highest rate since the beginning of 2011. The deflationary pressures stemming from the lifting of the minimum CHF/EUR exchange rate in January 2015 seem to have dissipated. Thanks to a weaker Swiss franc against the euro, higher levels of consumer and business confidence and the global economic upswing, which will benefit Swiss exporters, the economic outlook is cautiously positive.
Eurozone economies grew in aggregate 2.3% year-on-year in the second quarter, again above average. Germany and Spain provided the strongest positive impulses. Growth in France and Italy was somewhat weaker, but these economies were also able to maintain the pace of growth recorded in the previous quarter, with 1.8% and 1.5%, respectively. Labour market conditions improved accordingly, with unemployment reaching its lowest level since the global financial crisis (9.1%). Discrepancies among member states remain however. Far below the regional average is the German unemployment rate at 3.7%, whereas 17.1% of the Spanish labour force remains unemployed. Nonetheless, this is roughly two percentage points below the 2016 level and further improvement is to be expected. An initial estimate of the September PMI suggests an increase to 56.7 points. Furthermore, the European commission’s economic sentiment indicator reached a 10-year high in August. Analysts have consequently revised up their growth forecasts for the euro area by half a percentage point since the beginning of the year and now expect a 2% expansion for 2017. Nevertheless, inflation remains subdued and is only slowly edging up to the "close to 2%" target set by the European Central Bank (ECB).
US GDP growth rebounded from a weak first quarter and reached 2.2% year-on-year in the summer months. The key driver of this second quarter strength was solid private consumption supported by favourable financial conditions and the tight labour market. The unemployment rate remains at 4.4%, a 10-year low. Initial claims for unemployment benefit, an important early indicator of the US economy, rose in September compared to the previous month but remain at low levels in historical terms. Despite close to full employment, cost pressures remain subdued. Inflation, as measured by the personal consumption expenditure (PCE) index (the US central bank’s preferred price inflation measure), is just 1.4% (excluding energy and food prices).
The Federal Reserve Bank (Fed) considers this weakness as transitory and remains confident that inflation will reach the 2% target over the medium term. Indeed one-off effects such as price cuts for mobile phone services have played an important role in dampening inflationary pressures recently. The overall outlook for the US remains positive. An initial estimate of the September PMI, however, suggests a modest pullback. Hurricanes Harvey and Irma, which hit Texas and Florida in August and September respectively, will temporarily dampen US data in the near future before a further upswing is expected.
In light of the improving global economy and the recovery in the labour markets, monetary policy normalisation is being discussed more and more. In the aftermath of the Great Financial Crisis, which started almost ten years ago, policy rates were reduced to record lows and central banks purchased securities worth billions as part of their extraordinary policy such as quantitative easing (QE) programmes. These measures provided the financial system with the needed liquidity, pushed long-term interest rates even lower and curbed market volatility, but also caused the balance sheets of reserve banks to swell significantly. The balance sheets of the Fed and the Japanese central bank (BoJ) have increased fivefold since 2007, and that of the Swiss National Bank (SNB) tenfold. Overall, the global financial system has been supplied with around USD 14 trillion of additional liquidity by the central banks of the USA, Switzerland, the Eurozone, Japan and China over the past ten years. This liquidity support will gradually decrease with normalisation.
In the coming months, two of the largest central banks will begin to slowly withdraw some of their accommodation, but the flow of liquidity will remain positive on a global scale in the near term. In October, the Fed will start reducing its USD 4.5 trillion balance sheet. This will supposedly be done passively and gradually, in order to minimize any potential market volatility. Initially, USD 6 billion less will be reinvested in maturing US government bonds, and USD 4 billion less in mortgage-backed securities (MBS). These amounts will be increased every three months until a ceiling of USD 50 billion per month in total is reached. For this year and the next, this means a reduction of USD 30 billion and USD 370 billion, respectively. Looking at this in the context of the USD 1.8 trillion that the major central banks (excluding the Fed) have pumped into the financial markets during the last year, the outflow will not be particularly noticeable. In Europe, the ECB is expected to slow down its monthly purchasing of EUR 60 billion of bonds from 2018 and onwards.
Content: Interest rates, Switzerland, Europe, USA
Trends Q3: In the third quarter, ten-year government bond yields rose slightly in Switzerland, Germany and the USA towards the end of July, before the market uncertainty rose as a result of sabre-rattling between Washington and Pyongyang. After a fall in interest rates by the beginning of September, which led to a quarterly low in yields of -0.16% in Switzerland, 0.31% in Germany and 2.04% in the US, interest rates rose after the publication of surprisingly aggressive key interest rate forecasts by the US central bank, and reached -0.02% in Switzerland, 0.46% in Germany and 2.33% in the USA by the end of the third quarter. Key interest rates were not adjusted in any of the reviewed currency areas during the third quarter.
Outlook: It is expected that the Fed will increase its policy rate by another 0.25 percentage points at the end of the year. Whether it is likely to raise the key interest rate by an additional 0.75% in 2018, as suggest by the dot plot, is questionable given subdued inflation dynamics. In a speech at the end of September, the Fed's chairman, Janet Yellen, qualified central bank's relatively aggressive interest rate forecasts with the following statements: “The downward pressure on inflation may prove to be unexpectedly stubborn" and "the economic outlook is subject to considerable uncertainty.” The reduction in the balance sheet is likely to lead to somewhat higher interest rates in the long term, but the effect is likely to be limited due to the moderate extent of the reduction. In a recently published study, the Fed estimates that the planned balance sheet reduction could lift the yield on 10-year US government bonds by around 30 basis points by the end of 2018. At the same time, other factors such as geopolitical uncertainties are countering this movement.
Due to the robust economic upswing and stable inflation outlook, the voices of critics of ultra-loose monetary policy are becoming louder. A reduction in bond purchases has the potential to increase the record-low credit spreads of corporate bonds as well as the general interest rate level in the medium term.
Major turbulence should not occur, as market participants are already expecting the first step toward a more restrictive monetary policy.
The Swiss central bank is benefitting from the appreciation of the euro against the Swiss franc. This should support economic recovery and lead to slightly higher inflation rates. The SNB will, however, be careful not to counteract the easing in the exchange rate by the end of the year with a premature interest
Content: Equity market developments, share buybacks
Trends Q3: The global stock index reached an all-time high in September and equities in Switzerland, the Eurozone and the USA also continued to move upwards. Since the end of June, the Swiss Market Index (SMI) has increased by a further 2.8%. The Euro Stoxx 50 and the S&P 500 rose by 4.4% and 4.0%, respectively. All three indices have risen by about 10% since the start of the year. Even if they only trade sideways for the remainder of the year, 2017 would be the best year for Swiss and European equities in the last four years and the best since 2014 for American stocks.
The geopolitical environment contributed to short-term volatility and share price declines during this quarter. North Korea threatened to attack Guam, a US territory, in early August, and President Trump threatened "fire and fury" in return. However, this triggered only minor losses. Although implied market volatilities did increase somewhat temporarily, they remain at historic lows. The quarterly average of the implied volatility for the American S&P 500, measured using the VIX Index, is just under 11%, which is almost half of the 20-year average of 20.6%. There are similar trends in the Eurozone and Switzerland.
Outlook: We continue to see a positive market environment for equities, but risks are rising. The main drivers of the equity rally have been the global economic upturn, rising corporate profits and expansive monetary policy. These will remain positive forces, but are likely to ease somewhat over the next 12 months.
Historically high valuations are fuelling doubts that the rally can go on for much longer. American stocks in particular appear expensive. The valuations should, however, be viewed in the context of the macroeconomic environment as illustrated in Figure 12. The earnings yield, the inverse value of the price-toearnings ratio, of the S&P 500 was below the current value in only about 17% of cases during the period under review, which suggests rich valuations. If the interest rate environment is taken into account and the relative earnings yield, i.e. the difference between the earnings yield and the 10-year interest rate, is used as a measure, there is no significant overvaluation because in about twothirds of cases the relative earnings yield was below its current value. In the US, however, corporate debt developments should be monitored. Outside the financial sector, corporate debt has increased again in recent years, by more than GDP. One reason for this is that many US companies have used the low interest rate environment to finance share buybacks. Such buybacks have bolstered equity prices in the past, but have declined since mid-2017, leaving less support for prices but still high levels of debt.
The shift in monetary policy poses an even greater risk for the following two reasons: Firstly, the above-mentioned liquidity injections made by the major central banks have curbed market volatility in recent years. With the withdrawal of this liquidity, albeit only to a moderate extent, the susceptibility to higher market fluctuations increases. Secondly, investors expect a very moderate and slow tightening of monetary policy by the Fed and the ECB. If, however, this is done more aggressively than thus far communicated, this would trigger a correction. In addition, political risks, which on balance increased in the third quarter, could also lead to an unexpected risk-off scenario.
Content: Currencies, Exchange rate movements, Euro strength, Dollar weakness
Trends Q3: The Swiss franc remained stable relative to the USD dollar during the summer months but has weakened significantly against the euro. Since the beginning of the year, the euro has risen by 6.6% against the Swiss franc, which is likely to please both the Swiss export industry and the Swiss National Bank. According to the development of the Swiss franc denominated sight deposits at the SNB, the national bank has not intervened in the foreign exchange market. The strength of the euro is therefore attributable to the strong economic dynamics in the Eurozone and the expected tapering of QE. Recently, the euro fell slightly following elections in Germany. Investors welcomed Angela Merkel's election victory. But the news that her party's share of the vote had decreased significantly and that a new coalition was now required was less well-received. In addition, the right-wing populist Alternative for Germany (AfD) succeeded in winning seats in the German parliament.
Outlook: The euro is likely to come under pressure again in the face of political tension. Catalonia's referendum on independence from Spain at the beginning of October admittedly lacked democratic legitimacy, but will create some volatility in the short term. The largest political test for the euro will come at the latest in the second quarter of 2018, with parliamentary elections in Italy. The fear is that a change of leadership could lead to a referendum on withdrawal from the Eurozone. However, with the appointment of Luigi di Maio as the 5-Star Movement's candidate for the elections, these fears have faded somewhat, as he is considered more moderate and less populist.
From a monetary policy perspective, the next few months should see a strengthening of the US dollar as another interest rate hike in the US is expected, which would further widen the interest rate differentials vis-à-vis the Swiss franc and the euro. The ECB's expected tightening of QE is likely to continue to support the euro against the Swiss franc. If the ECB does not terminate the QE programme during 2018, as most analysts expect, the euro would depreciate again.
Bloomberg Finance L.P., BIS, FRED, Eurostat, OECD, IMF, SNB, ECB, KOF, SECO, IHS Markit, European Commission, FEDS, Federal Reserve Bank of New York, editorial deadline: 30.09.2017
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