Betting on the Non-Evident

Q4 2017 Review and Outlook

Betting on the Non-Evident

We believe the year 2018 will shape up to be another year of strong global growth. Many emerging markets remain in the virtuous phase of the economic cycle, while the U.S. should finally start to experience wage and price pressures.

Betting on What’s Not Evident: Something More Normal

Over a year ago we argued that the case for “secular stagnation” might be on its last legs. Our theme at the time was “Stirrings of an End to Financial Repression.” Cautiously optimistic, we were very aware that our views were out of step with the seemingly bulletproof case for perpetually miserable nominal growth, handcuffed by bad demographics and weak productivity.

Three structural factors drove our contrarian sense of optimism:

  1. First, household deleveraging in the U.S. went on hold and in association, China’s economic trajectory had stabilized. The collapse in the U.S. household debt super-cycle and the consequent plunge in Chinese production growth were at the epicenter of the post-crisis stagnation. Stabilization in these elements meant something very different was already in play. Could it be that the world is normalizing away from the near decade-long after-effects of the Great Financial Crisis (GFC) toward a newer but more familiar self-sustaining business cycle expansion?
  2. Second, the thrust of fiscal and monetary stimulation is unprecedented for this point in the global expansion—no premature tightening this time. Central bankers are nervous about lingering deflationary undertones in the world economy, not to mention anxious about the impact of normalization on asset price inflation. In the meantime, fiscal policy around the world is getting more stimulative, not less.
  3. Lastly, the oil bust has given the global consumer a multi-trillion-dollar savings boost. This powerful growth catalyst for consumers of energy is a boost which grows with time.

2017: A Year for Contrarians

And 2017 did indeed turn out to be a big positive macro surprise. The breadth and strength of the expansion last year was unprecedented, with more countries participating in the world expansion than at any time in the last 25 years. In the U.S., the S&P 500 rose every month of the year—which has never happened before—and another quarter of 3% growth would be the first time in 12 years that the U.S. economy has experienced three consecutive quarters of +3% annualized growth. European business confidence continued to soar. Japanese corporate profits in response to Prime Minister Shinzo Abe’s initiatives methodically marched higher and/or at multi-decades high.

Investor sentiment on the economic outlook has shifted away somewhat from the secular stagnation blues over the last 18 months. What remains fascinating is how difficult it seems for investors to believe in a brighter future. After rebounding in late 2016, growth expectations have retreated all year, based on the Bank of America Merrill Lynch monthly global fund manager survey! Perhaps a sense of “this is as good as it gets?” Or is it because focus has shifted to the U.S. raising rates, the prospect for an end to quantitative easing in Europe this year, and China’s shift to a quality growth plan? Either we are naively optimistic or investors have an obsessive-compulsive objection to the idea that the drag on the business cycle from the GFC is winding down.

What Is the Yeld Curve Saying?

The U.S. yield curve continues to flatten with 30-year Treasury yields still marginally below where they were when the Federal Reserve (Fed) raised interest rates for the first time in December 2015. It is normal for the curve to flatten when the Fed raises rates. It is not normal for bond yields to be flat or even slightly lower while this happens. Importantly, there are no signs of recession! The outlook for profits is upbeat and there are none of the usual end-of-cycle yellow flags like excessive credit growth and/or rising price inflation. If anything, the U.S. appears to be in the mid-cycle sweet spot. This leaves a couple possibilities.

  • One is that bond investors do not believe U.S./global nominal growth can move much higher, and/or that the Fed will preempt any incipient upturn in inflation. Part of this perception might be related to the persistently low wage and price inflation rates. However, the failure of real bond yields to increase would imply that investors are skeptical even of sustainably better real economic growth. That is not the message from the stock market.
  • Another is the transmission effect of breathtakingly large bond purchases by the European and Japanese central banks. The level of European bond yields is unambiguously anomalous: a large portion of European and Japanese sovereign debt trade with a negative nominal yield; the yield on Italian 10-year sovereign debt is almost 50 basis points lower than 10-year Treasury notes; European high yield corporate debt is trading at almost the same yield level as Treasury notes. Fixed income outflows from Europe reached almost $600 billion over the past 12 months—trillions since 2015. It seems unreasonable to believe that the scale of these distortions and flows is not having an effect on Treasury yields, flattening the global yield curve and helping to foster global growth.

The Economy Cuts through the Noise

The background noise to the economic story is deafening: fake news and disinformation, cyberwar, the threat of real war, the decline of American hegemony, the competition among emerging regional hegemons and geopolitical realignment, the threat of protectionism, and the spread of populism.

So far, the economic story appears to be trumping all these potential drivers of risk aversion. What is more important than the risks are how policymakers are reacting to them. The policy reaction is tantamount to doubling down on capitalism’s ability to deliver growth: global tax reductions, massive infrastructure spending—at least in China—and significant deregulation, at least in America. The year 2018 is shaping up to be another year of strong global growth.

Elected on a populist ticket, President Donald Trump has just incentivized owners of productive capital and small businesses to invest and grow by slashing the statutory corporate tax rate, instantly boosting the value of the country’s capital stock. There is an intense debate among economists over the size of the fiscal stimulus from this initiative. Common sense suggests the reduced corporate tax rate should be positive over time for small businesses, encouraging multinationals to repatriate their cash hordes and developing more business at home. Most Americans will get a modest tax cut, with the exception of some in the high-taxed states because of the cap on deductibility.

The Tax Story Is Global

The Trump tax cuts get the headlines but the tax cut story has been playing out across the world well before the Trump budget.

  • In France, the government has introduced plans to cut corporate taxes on profits over €500,000 to 25% by 2022, from 33.3 % currently, and has slashed its wealth tax on everything but property, and introduced a flat tax rate on capital gains, dividends, and interest of 30%.
  • Belgium wants to cut corporate taxes from 34% to 24% by 2021.
  • The Netherlands has cut the corporate tax rate to 21% from 25%, abolished the 15% dividend tax, lowered the wealth tax, and raised the value-added tax (VAT).
  • The recent Austrian elections focused on immigration, but newly elected Chancellor Sebastian Kurz campaigned on a supply-side platform, calling for a $14 billion tax cut for job creation, the elimination of the corporate minimum tax, and a reduction of wage and income taxes.
  • Prior to the recent German election there was consensus among the Christian Democratic Union (CDU), Social Democratic Party (SPD), and Free Democratic Party (FDP) to eliminate the 5% solidarity tax surcharge on incomes above the top 45% tax bracket.
  • In Japan, Abe has been chopping away at corporate tax rates since taking office. The rate was 38% when he assumed power and is currently at 29.7%, which may have much to do with the explosion in Japanese corporate profit margins. If so, it may be a harbinger of what is coming elsewhere in the world. More recently, Abe is incentivizing further cuts for companies who boost wages.
  • Hong Kong cut the corporate tax rate for certain groups of entities from 16.5% to 8.25% early in 2017, to attract firms from outside Hong Kong; a second, two-tier tax-reduction scheme is currently under consideration.
  • Australia has started to consider a corporate tax cut.
  • China, too, has drawn attention to the need to stay competitive globally.

Most North Atlantic Treaty Organization (NATO) countries are boosting military spending in reaction to the decline in American hegemony and to the Trump Administration’s demand that NATO allies meet their financial and military obligations, in turn boosting economic growth. Similarly, China will spend billions, if not trillions of dollars, on its “One Belt, One Road” project partly as a means of establishing its status as regional hegemon.

In the meantime, the unwinding of unorthodox global monetary policy is going to be very slow. We could review the global landscape but simply put, central banks are going to be late to tightening in this expansion. They want to see the “white of the eyes” of inflation before they move.

Inevitably there will be a point where capital markets may compete with the real economy for liquidity, as central banks gradually go into reverse. In the meantime, negative real rates and low volatility are like two peas in a pod. The reversal is a story for the second half of 2018.

Assessing China’s performance is crucial for the global outlook. China led the most recent rebound in global economic activity on the back of a significant credit impulse in 2016. That impulse has turned into a drag, as credit growth peaked out and then moderated, and has more recently manifested into softer property prices and real estate activity. Most analysts model money growth and real estate sales to forecast future growth; these indicators have pointed to a decent slowdown for the past year. We have taken the other side of the debate.

Relative to that expectation, the most likely surprise would be better numbers.

The Most Likely Surprise: Better Numbers

Leading economic indicators (LEIs) from both the Organization for Economic Cooperation and Development (OECD) and China’s National Bureau of Statistics are rising. Normally these indicators correlate well with various measures of China’s industrial activity. Lately these measures have been diverging, a sign that excess capacity/supply has been shrinking under the administrative guidance of policymakers. Yet the LEIs suggest other sectors of the economy are picking up the slack, notably the consumer and the services sectors. Although fixed investment remains nearly stagnant, industrial profit growth is robust and the services sector has climbed to more than 50% of the economy. One surprise could be the extent to which China has already reduced excess industrial capacity and bloated real estate inventories while championing investments in green technology, healthcare, and information technology.

Financial Markets in Fourth Quarter 2017

Although Europe faced its own series of political events, improving economic and sentiment indicators eclipsed these factors. Intermediate- and long-term French OATs and Italian BTPs rallied due to a combination of modest economic expansion and in France’s case, pending reform. Portuguese sovereign debt extended its year-long rally as economic fundamentals improved and Fitch raised its bond rating. Eurozone consumer confidence hit a 16-year high; optimism in the region helped the euro climb higher. The Bank of Japan (BoJ) remained committed to accommodative policy; its stance was reaffirmed by Prime Minister Abe’s reelection. Japanese government bonds (JGBs) rallied due to the continuation in stewardship and nascent signs of inflation. The Bank of England (BoE) raised its policy rate for the first time, helping longer-dated gilts rally as the Fed raised the fed funds rate at its December meeting and expressed its commitment to the 2018 dot plots. Other central banks have been hesitant to grow less accommodative; central bank trepidation toward policy normalization weighed on the Norwegian krone, which did not rally in spite of improving commodity prices and global trade. The Malaysian ringgit rallied as the government sought to address the fiscal budget deficit, implement reform to improve the business climate and infrastructure, ahead of a 2018 election cycle. Indonesian government bonds rallied as firmer commodity prices boosted export prices.

Emerging Markets

Heading into 2018, we are relatively pessimistic about duration in developed markets. Where we are constructive is in emerging markets, where real yields are high and currencies are undervalued, and where we believe returns could come from both the currencies and the bonds.

Many bond markets of the emerging world remain in the virtuous phase of the economic cycle. A few years back they were in the vicious phase: dollar strength drove weak emerging market currencies, which fostered domestic inflation. Central banks reacted by raising rates—which only further weakened their economies, drove their respective currencies lower, inflation higher, and so on. These forces have reversed and have yet to be completely unwound. Historically, what has caused trouble for the emerging world has been aggressive tightening from the world’s de facto central bank, the Fed.  Neither aggressive Fed restraint nor dollar strength are elements we envisage for most of 2018.

The U.S. Dollar

Both price and information risk drove our dollar strategy in 2017. At the start of the year, we judged the dollar as one of the most expensive currencies in the world. In addition, there was a strongly held view that tax cuts were inevitable and dollar bullish. This view meant that any disappointment relative to that expectation would weigh on the dollar. The Trump Administration’s fumbles over the repeal and replacement of “Obamacare” played to this theme. In addition, it was never clear just how much direct fiscal stimulus would flow from the tax package. More fundamentally, our view is that capital is attracted to growth and the growth surprises in the world last year were playing out in Europe and a variety of emerging countries. Lastly, we take the view that capital markets are stabilizers of growth. We surmised at the start of the year that a strong dollar was not in the interests of a sustainable and balanced global growth expansion, and was therefore unlikely.

The drop in the dollar has obviously reduced the price risk profile of the currency compared to this time a year ago. Global growth is more balanced than a year ago too, and so far, currency markets have not validated the expectation that The Tax Cut and Jobs Act of 2017 will be bullish for the dollar. This seems in line with our view that the direct effects are not that significant, and also recognition that the U.S. is not the only country in the world cutting taxes. Under these circumstances, we continue to believe that a significant rally in the U.S. dollar would not be in the interests of the global economy and would be equivalent to a premature tightening in global monetary policy. It does not take much for some of the higher-yielding emerging countries with undervalued currencies to outperform. The passage of time may alter our views, as would a period of significant weakness in the dollar.


Applying our price and information risks versus opportunities process inevitably brings us to Mexico. Given how significant bonos1 are across most of our portfolios, there is the question of how we are managing the uncertainty fostered by the U.S. administration’s upcoming decision on whether to withdraw from NAFTA. 

Markets hate uncertainty, and it is true that there is much to worry about in Mexico. However, the extreme depression in the currency strongly suggests to us that much of this is already priced in and that a resolution of the uncertainty, one way or another, will be constructive for the currency much in the same way that the peso bottomed the day of President Trump’s inauguration. What is evident is that domestic demand is contracting based on auto sales, real retail sales growth, and the slump in credit growth. Rising headline inflation has also weakened real incomes—which have been depressed further by central bank tightening to fight this inflation. We know that there is a swing to the left and populism given the popularity of Andrés Manuel López Obrador. Much of this information is in the price of the currency. At its low in 2017, the peso was trading at a discount to some measures of fair value against the dollar that was as depressed as 1998, during the emerging market crisis. It is currently not much higher and one of the most undervalued currencies in our investable universe. In other words, Mexico is on the threshold of a swing from a vicious to virtuous economic cycle.

South Africa

The experience of other emerging market countries with event risk is notable in this respect as well. The South African rand experienced a period of volatility after President Zuma sacked his finance minister. The prospect of the country being led by a corrupt president seeking to undermine institutional checks and balances fostered a lot of pessimism, culminating in Standard & Poor’s decision to downgrade the country’s local-currency debt in November 2017. Yet the rand, another depressed emerging market, has returned to where it was before former finance minister Pravin Gordhan was fired, while 10-year yields are lower.

Conclusion: Betting on What’s Not Evident—Cautious Optimism

Last year, we bet on what was not evident, and few believed. This year, all the evidence continues to point to the world pulling away from secular stagnation and toward a self-sustaining business-cycle expansion, again something that few seem to believe. We are bombarded and reminded daily of a litany of risks. Yet, the primary response to these risks has been for policymakers to boost capital’s incentive to grow in the presence of persistently accommodative monetary policy around the world. If this year’s negotiations to reestablish a new world order in trade turn out to be more posturing than policy, then we should see a strong self-sustaining global economic advance associated with a flat-to-weaker U.S. dollar, mildly rising rates in the developed world, and flat- to-falling rates in the emerging world.

We thank you for your continued support.


1 Bonos are a type of Mexican Government sovereign bonds, denominated in Mexican pesos.


IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.