With U.S. Driving, Global Economy Ticks Up

Politics continued to drive much of the news in March. On March 16, the Trump administration released an overview of their “skinny budget”, which forecast large reductions for specific departments while planning increases for defense spending. Furthermore, Republican leaders introduced the much anticipated American Health Care Act, targeting the repeal and replacement of the Affordable Care Act; however, the bill failed to gain traction in its current form and ultimately never reached a vote on the House floor.

Interest rates continue to rise. The Federal Reserve increased the target fed funds rate by 0.25 percent on March 15. This was no surprise as the rate increase was mostly priced in prior to the meeting. The Fed members project an estimated three rate hikes this year. In 2017, US equity markets have started off well reflected in the S&P 500 index up 6.31 percent as of March 30. However, the rally slowed recently with the S&P up only 0.34 percent for the month to that point.

Across the Atlantic, the political focus has been on the elections in the Netherlands. Current Prime Minister Mark Rutte kept his position by holding off anti-European Union challenger Geert Wilder. This reduces risk of European populism in the near term, although longer-term risks remain.

Economy

Growth and inflation around the globe appear likely to increase in 2017. Monetary policy is very loose around the world and is slowly taking hold are improving in most countries. UBS projects Global Real GDP growth of 3.6 percent in 2017 and 3.7 percent in 2018. Easy financial conditions, strengthening business sentiment and stabilization of the energy sector are all helping to increase global growth.

The improving U.S. labor market should help consumer spending. Additionally, business investment should be poised to increase. The interest rate increase by the Fed on March 15 represents the third policy rate hike for this cycle, with more hikes likely before year-end. This move reinforces the Federal Reserve has a solid opinion on the state of the U.S. economy.

Interest Rates and Inflation

When it comes to current Fed policy, investors and
markets are focused on the final destination of interest rates. Most bonds have interest payments and maturity dates much further out than five years. while economic conditionsTherefore, the final “target rate” the Fed lands on in this cycle is significantly more important to the fixed-income market than the timing of the rate hikes this year.

Inflation expectations over the longer-term are likely to remain contained. Keep in mind the Federal Reserve is increasing rates while inflation is still below target levels. This should allow the Fed to stay ahead of the curve when it comes to inflation. To this point, inflation expectations for the long-term are still consistent with the2 percent target forecast from the Fed. If this persists, rates on the short end of the yield curve may continue to rise while long U.S. yields have mostly priced in this forecast.

Five years ago, the Fed forecast the real interest rate to be 2.25 percent. Based on current Fed’s projections, interest rates are expected to peak at nearly 3 percent, with long-term inflation forecast at 2 percent. This would infer an approximately
1 percent real interest-rate level (3 percent fed funds rate–2 percent inflation=1 percent real interest rate).

The Fed projects long-term growth in the U.S. economy at 1.6 percent to 2.2 percent. Should the projections regarding real interest rates play out as expected in the 1 percent range, it would be probable for U.S. economic growth to be higher than real interest rates. Equities should find this environment to be supportive.

Equities

UBS favors U.S. and global equities over government bonds as they believe solid corporate earnings remain sup-portive of higher prices in stocks. Most regions are seeing increasing corporate earnings, which are being supported by demand from consumers, increased prices in commodities and higher capital expenditures. Using price-to-earnings ratios, valuations around the world are slightly above long-term averages, which should leave some room for additional price appreciation propelled by increasing corporate earnings. Equities around the world should benefit in general from “risky assets” outperforming. However UBS expects the recovery will continue to be led by the U.S. economy.  

(Supportive information on global market and economic expectations can be found in the “UBS House View–Investment Strategy Guide–April 2017”-pages 5, 6, 11, 14.  http://financialservicesinc.ubs.com/staticfiles/pws/adobe/House_View_ISG_04.17.pdf)