The global economy, listless these past few years, looks ready to rise, stretch and get a move on again. This new momentum could push global economic growth to 3.4% in 2017, compared with an estimated 3% annualized growth rate for 2016, according to Morgan Stanley Research.
Faster growth in the U.S. and Japan is expected to offset Europe’s slightly slower pace in developed markets, while a rebound in commodity-exporting emerging markets compensates for China’s gradual slowdown.
In a late-cycle market, both ‘boom’ and ‘bust’ are more likely.
The upshot for investors: “While growth becomes more balanced, material risks emanate from late-cycle fiscal stimulus, faster Fed rate hikes and a broad globalization backlash,” says Elga Bartsch, co-head of global economics.
Such prospects for higher growth also come with greater risks. Chief among them: the political uncertainties unleashed in 2016—Brexit and the U.S. presidential election, to name but two—which will carry into 2017, as the Trump administration takes office in January, major European countries face key ballots, and formal talks kick off for the UK to leave the EU in March.
As a result, “investors will need to be nimble,” says Andrew Sheets, chief cross-asset strategist. Hope for fiscal stimulus in the U.S., higher earnings-per-share growth, and the return of more normative levels of inflation could buoy sentiment during the first quarter of 2017. By the second quarter, however, “tighter financial conditions, slower China growth and elevated policy expectations will loom large,” Sheets warns, and the bloom could fade. “In a late-cycle market, both ‘boom’ and ‘bust’ are more likely.”
Nevertheless, a number of positive macroeconomic trends are coming to the fore. Chief among them is the prospect of reflation. Recall that a couple of years ago, fears of persistently low inflation, or even downright deflation, prompted a number of central banks around the world to ramp up stimulus measures, such as quantitative easing. Inflation did begin to pick up in 2015, only to be derailed by China’s unexpected currency devaluation in August of 2015. Collapsing oil and commodity prices didn’t help, dampening growth in commodity-rich emerging markets.
The tide has turned. Stronger growth momentum, better prospects for oil and other commodities, and the dollar’s appreciation against other major currencies, such as the euro, pound and yen, could cause inflation to hit or even exceed central-bank targets over the next two years. The more this move comes with firmer wage growth and better corporate profits, the better the scenario for markets and investors.
Central banks around the world, which earlier in 2016 were contemplating radical new tools, such as negative interest rates, are expected to shift gears. The Federal Reserve, in particular, could embrace a faster pace of rate hikes—with as many as six increases between now and the end of 2018, Morgan Stanley Chief U.S. Economist Ellen Zentner predicts.
Higher rates will make the dollar stronger. That and the looming threat of protectionism—if the Trump administration pursues its campaign rhetoric—could challenge the nascent recovery in trade-reliant emerging markets, Bartsch says. For now, commodity exporters, notably Russia and Brazil (both countries are returning to positive growth after deep recessions), are driving that recovery. Growth in China, by contrast, is expected to keep slowing, while the rest of Asia, excluding Japan, stays broadly stable.
Meanwhile, given the many political uncertainties that remain, the European Central Bank is unlikely to end quantitative easing until the second half of 2017. Although Brexit hasn’t dented EU growth materially, if the voter discontent that swept the UK in June and the U.S. in November continues its march through key ballots in Italy, France and Germany, financial markets wouldn’t be immune to the stress of such geopolitical uncertainties.
Hence, 2017 will feature a broader distribution of possible outcomes. “The gains in a plausible bull case look larger than before, fueled by the prospect of fiscal expansion, rising earnings and a return of true ‘animal spirits.’ But the downside tail has also grown,” Sheets says.
The advice from Morgan Stanley’s global strategists? Sell credit to buy equities, which is the opposite of their call last year. Within equities, sell U.S. and emerging market equities to buy Japanese and EU equities, also the opposite of their regional equity view at this time last year. In currencies, favor the dollar while eschewing the yen, won and renminbi. Sell long-end eurozone rates, as central bank policy nears the “end of easing” in developed markets, and go underweight corporate credit against securitized products and emerging-market hard currency debt. Own volatility in equities, credit and rates, where their bull-bear range is wider than market pricing.