Don’t underestimate the US economy surprising to the upside and the Federal Reserve raising interest rates at a more rapid pace than expected this spring, according to Adrien Pichoud, chief economist at SYZ Asset Management.
While Europe has been the surprise package for much of the past two years, with 16 months of uninterrupted positive economic surprises for the eurozone, now could be the time for the US to return to favour.
“As the old German saying goes, ‘trees don’t grow to the sky’. This certainly applies to economic surprise indices that compare actual economic data to market expectations – they are by definition mean-reverting,” said SYZ chief economist Pichoud.
Performance of indices since July 2016
Source: SYZ Asset Management
Although the European economy has performed particularly strongly recently, investors have been slow on the uptake, with market consensus only moving to a positive stance on the European growth outlook when GDP growth settled above 2 per cent.
However, the potential for positive surprises has diminished, as more is now expected from the European economy moving forward.
“Then the inevitable happened: confidence and activity indices edged down from their record high levels in February and dragged the Economic Surprise Index into negative territory,” Pichoud added.
“Such a decline simply reflects the fact that the still positive growth outlook for the Eurozone is now largely expected.”
While there is less potential for upside surprises, the SYZ chief economist said investors still have much to cheer as economic data continues to show solid growth across all economies and sectors.
“Purchasing Managers' Index (PMI) data in the manufacturing and service sectors still point to annualised GDP growth of around 2.5 per cent – more than twice the long-term potential growth rate,” Pichoud said.
He explained: “The GDP data for Q4 2017 strengthened this picture: eurozone output was up 0.6 per cent, led by strong expansion in Spain and Portugal, who were up 0.7 per cent, and also in Germany and France, who were up 0.6 per cent.”
Italy, whose recent general election returned a hung parliament and cast some uncertainty over who will lead the country, expanded at 0.3 per cent but its GDP remains some way off 2011 levels.
By contrast, the catch up of the Spanish and Portuguese economies after their deep 2011-12 recession is “spectacular”, according to Pichoud.
“Portugal just recovered its pre-recession GDP level, offsetting an 8 per cent decline and Spain keeps growing at an enviable 3 per cent yearly rate that even mighty Germany is not able to sustain,” he said.
What could be the real surprise for investors however is the US, as the impact of tax reform is gradually discounted in economic forecasts, said the SYZ economist.
But this will likely coincide with an accelerated course of interest rate hikes from the Federal Reserve, particularly after the US economy accelerated last year and president Donald Trump got his package of tax reforms approved.
“Concerns around the US growth dynamic and its sustainability have vanished. All eyes are now on inflation-related data and its impact on future Federal Reserve monetary policy,” the chief economist said.
Inflation indices since 2002
Source: SYZ Asset Management
The path of rate normalisation is key for financial markets that have been accustomed to low rates for so long.
“The favourable global economic backdrop warrants a normalisation of US credit conditions; such normalisation can be implemented gradually, as long as the pace of price increases remains mild,” Pichoud said.
“Any unexpected acceleration in inflation, on the contrary, could lead the Fed to tighten its monetary policy more rapidly.
“In this context, no wonder a small spark, such as higher-than-expected hourly wage growth, can trigger a spike in volatility like the one observed in February – even if this data is expected to be revised lower a month later, as it happened in this case.”
For now, price and wage gauges of inflation remain at subdued levels and do not require the Fed to become more aggressive but it will be key to watch these figures moving forward in the coming months.
One area investors should not expect to see any interest rate policy from is the Bank of Japan, which Pichoud said is not ready for monetary tightening.
“Despite the well-known negative correlation between the yen and the Japanese stock market having weakened last year, this relationship came back into the spotlight in February,” he said.
“While global stocks rebounded after the selloff, the Topix index and the Nikkei 225 failed to follow and dropped further, mainly because of the yen’s jump.”
Performance of indices over 1yr
Source: SYZ Asset Management
This sharp currency appreciation was triggered by a comment from governor Haruhiko Kuroda saying the central bank would consider winding down quantitative easing in the 2019 fiscal year.
But as Japan is very sensitive to exports, moves in the yen tend to ricochet in the equity market, Pichout noted, meaning that it is unlikely he will be able to follow through on such promises.
“Kuroda’s comments demonstrate the currency remains fragile to external shocks and this should signal to the Bank of Japan the market is not yet ready for tightening,” he said.
“Moreover, inflation figures in Japan remain far away from the inflation target. Both elements lower the likelihood of a potential tightening.”