As the crisis engulfed the global financial sector and economies subsequently weakened, interest rates were cut sharply as central banks fought to protect against deflation. Indeed in some cases – Eurozone and Japan – central bank interest rates went negative.
In the not too distant past, such intense policy stimulation would have sharply boosted economic growth and probably triggered a resurgence of inflation as well. But this has been a far from typical economic recovery. Global growth has been sluggish and any inflation pressure has been little more than a damp squib.
The disillusionment of investors in the effectiveness of central bank policies to lift economic growth sufficiently has been manifest in the degree to which longer term interest rates (bond yields) have fallen.
But we may well be standing now at a turning point for global interest rates. This past year, economic activity indicators seem to have been popping higher everywhere. And it is the widespread nature of this pattern across so many different economies that are as impressive as the strength we are seeing in some of these numbers. It appears that the period of ultra-accommodative global monetary is finally gaining traction. Global economic growth is accelerating.
Quite why this is happening is not yet perfectly clear. The root cause may very well be nothing at all to do with ultra-low interest rates and everything to do with developments in China. This mega-giant of an economy powers around one third of global growth and is currently undergoing dramatic structural change which has seen a raft of economic indicators accelerating this past year. Alternatively, it may simply be a reflection of the fact that economies have finally repaired themselves sufficiently (banking sectors in particular) from the ravages of the global markets crisis.
Either way, this development has some important ramifications for the global investment environment and our outlook on 2018.
1. We do not expect the resurgence in global growth to fuel inflation pressure. The global economy’s ability to absorb stronger demand has been enhanced by the fast advancing frontiers of technology. There remains plenty of spare capacity in the global economy still to work off before reaching inflation buffers: this reflects the residual effects of the global recession and the strengthening embrace of capitalism across the developing world.
2. We do expect global interest rates (and bond yields) to move higher – though at a modest, measured pace. The US has been in the vanguard of the global economic recovery and the rise in interest rates here is already well advanced. Other central banks will follow suit over the next year or two.
3. The rise in interest rates should not damage the outlook for equity markets. Rather, it represents a response to strong economic growth which is positive for corporate profitability. Of course, equity markets that look uniformly positive and that have enjoyed a consistently positive run are prone to short-term corrections. And valuations do look stretched in some markets (particularly the US), especially in view of the fact that a key driving force has been the notoriously volatile tech sector. Accordingly, a short-term correction (of the order of 5%- 10%) appears almost inevitable at some point in 2018. But the strength of the global backdrop offers the market a good deal of fundamental longer-term support.
There are plenty of risks ahead of course, and investors are understandably nervous given how elevated equity markets appear when viewed in historical perspective.
Accordingly, it is critical to view these fundamentals in the context of our primary responsibility to protect our clients’ capital over the long term. And as positive as we are about ongoing supportive market conditions for risk assets, it is as important as ever to maintain a diversified exposure to a wide range of asset classes and geographies.