Economic outlook

July 11, 2014

123rf - wealthWe take a look at major developed economies and their economic growth and economic outlook for you to consider for your investment strategy.

US

Key considerations for fixed income investing

The Federal Reserve has continued to partially remove stimulus via further reductions in quantitative easing (QE) this year. Despite this reduction, US 10 year treasury yields have fallen from 3% in January to approximately 2.5%. We are not particularly concerned about the risk of inflation, which is usually the key driver of higher interest rates. There is too much excess capacity and structural unemployment in the global economy (especially in Europe) for us to be overly concerned of an inflation spike. However, The US Federal Reserve owns close to 35% of all US Treasuries with more than 5 years of duration remaining. There is a risk that rates could rise with the removal of Federal Reserve buying. As a result, we recommend investors allocate a significant proportion of their defensive assets to credit funds with minimal duration exposure, to reduce the risk of loss of capital if US 10 year government bond yields do indeed rise significantly.

Will stronger GDP growth lead to strong earnings growth and market gains?

Despite slow growth in the first quarter which was largely weather related, we believe US GDP growth in 2014 is likely to be in the vicinity of 2.5-3%, which is higher than the growth rates of 2013. Importantly, public sector revenues have improved due to stronger consumption and higher asset prices, which has led to higher tax receipts. The budget deficit is likely to decline to 3 to 4% of GDP, negating the need for major expenditure reductions or tax increases. The outlook for corporate capital expenditure is positive, and consumer confidence is robust due to recent gains in housing and equity prices as well as employment growth.

While the outlook for US GDP growth is reasonably positive, the outlook for corporate earnings is not particularly promising. First quarter earnings grew at close to 2%, and we are doubtful that consensus expectations for 8% earnings growth this year will be achieved. Tailwinds of reduced interest expenses, no real wages growth, productivity gains and US dollar weakness have been key drivers of US corporate margin expansion in recent years. A number of these earnings tailwinds have abated. Corporate margins may hover at their current historically high levels, but further margin expansion is unlikely to be significant. The U.S. dollar has strengthened against most major foreign currencies over the past year, which is a headwind for earnings growth (earnings from subsidiaries are worth less in US dollar terms and exports priced in local currencies are also worth less in US dollar terms).  Interest rates are likely to gradually increase in the years ahead, providing a further headwind to earnings per share growth. The consequences of this is not necessarily poor share market performance – but further price earnings multiple expansion is likely to be a prerequisite for any further equity market appreciation of considerable magnitude.

Europe

Expect slow growth and diversity in GDP growth rates

We expect Europe to exhibit slow, albeit positive GDP growth throughout 2014. Business and consumer confidence have improved, and this could lead to more robust business and consumer spending. The medium term inflation outlook in Europe is low, and is likely to fluctuate around 1% or less. Given the very high unemployment rate of close to 12% (with significant disparity between countries), and low workforce participation rates, wage inflation pressures are minimal. The output gap is also wide in Europe, with significant excess capacity. As such, with nominal GDP likely to grow at about 2%, European nations are less able to inflate their way out of their high net debt levels.

Banks remain in deleveraging mode, and credit conditions remain relatively tight. Growth rates between European nations are likely to remain varied – Germany is likely to exhibit more positive growth, with Spain and Italy continuing to lag.

The outlook for UK GDP growth is more promising – consumer spending is growing and business investment has finally started to exhibit some robustness. Inflation is also higher, equating to significantly higher nominal GDP growth than continental Europe.

Japan

Japan is likely to experience slower growth this year, mainly due to the sales tax increase in April 2014 from 5% to 8%, which is likely to dampen consumption, and also due to more constrained government expenditure post extraordinary stimulus in 2013. GDP growth is likely to be in the vicinity of only 1%.

Source: IOOF, May 2014

Our financial planners are ready to help with any economic or finance questions you may have.
Call (02) 4926 2300 or email us.

Disclaimer

The team at Leenane Templeton are here to help with any questions you may have in relation to economic growth, your investment strategy and the general economic outlook as a whole. Give us a call.

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