This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Alan Higgins, Chief Investment Officer, UK at Coutts gives his market outlook for the week.
Looking across the developed world from the perspective of inflation also highlights the likelihood of continued stimulus in Europe.
Japan may be growing out of the deflation mantle, and Europe is now striving not to take it up. Switzerland and Sweden continue to flirt with deflation, while eurozone inflation remained very low at 0.5% in June.
The monetary policy bias across Europe is therefore likely to remain loose, providing some offsetting liquidity to the global economy as the US Federal Reserve’s bond- buying programme looks set to wind down in October. Last month, the European Central Bank introduced a host of measures to stimulate the economy, and also hinted that it may introduce quantitative easing given very low inflation. Recent slowing in activity will add pressure on policymakers to do more to maintain recovery.
Following nearly two decades of deflation, Hiroshi Nakaso, Deputy Governor of the Bank of Japan, declared last week: “The conquest of deflation in Japan is now in sight.”
Though expectations for further stimulus from the Bank of Japan may be disappointed, as Nakaso noted, this would be good news for the Japanese economy and for global growth too.
The expectation of falling prices can lead to stagnant consumption and weak economic growth, which can put further downward pressure on prices. Once such expectations become entrenched, they can be difficult to escape from.
This has been Japan’s experience and is the reason central bankers around the world are striving to ensure their economies don’t suffer a similar fate. We look for continued gradual improvement in global economic growth.
Equities: US Profit to Beat Low-Ball Forecasts
Early signs from the US earnings season suggest results will beat low-ball estimates, supporting our view that equities will make modest gains this year and outperform bonds. Of the 70 companies that have reported third-quarter results so far, 60% have beaten forecasts, which – as usual – were downgraded in the run-up to the reporting season.
We expect growth in net income from the previous quarter, and for the market as a whole to beat expectations. This will in part be due to generally lower input prices for many companies after high energy prices caused by extreme winter weather. US equities have typically been supported when results beat expectations, and we expect this still to be the case. However, due to high US valuations and the greater recovery potential in European earnings, we remain underweight the US and overweight in Europe, while also remaining overweight equities in general relative to bonds.
Bonds: Look for Better-Priced Inflation Protection
We continue to forecast modest inflation in the US and UK over the next year, though risks are skewed to the upside. We maintain a neutral view on inflation-linked bonds relative to nominal government debt – in other words, we see no advantage in linkers over nominal bonds – given negative real inflation-adjusted yields and weak inflation.
UK and US 5- to 10-year breakeven rates, a measure of inflation expectations, look fairly valued given inflation has stabilised at low levels. That said, faster-than-expected growth could cause real yields to rise and weigh more on linkers than nominal bonds in the short term. We see few catalysts for rising inflation at the moment, but any rise in UK real yields, lower linker prices, could be an opportunity to buy cheap insurance against longer-term future inflation.
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