Rising US growth outperformance has been a key feature of the macro environment in recent months. At Goldman Sachs Asset Management, we think this is now turning as US growth is likely to moderate from the strong pace in the second quarter and converge somewhat with the rest of the world. We think this convergence creates the potential for a comeback in emerging market assets.
We expect some moderation in US growth and continued consolidation in the long-end of US rates to be important aspects of the macro environment towards year-end. We think concerns about trade and EM contagion are overdone. We expect this macro environment to drive a comeback in EM assets after their recent underperformance.
From growth divergence since the spring …
Earlier in the year, we highlighted 1) upside risks to the US and Japanese growth outlook; 2) downside risks for Europe and China; and 3) reduced interest rate risk after the sharp rise in rates we had seen. Together we thought these developments created a better balance of risks. Since then, the S&P 500 reached a new high and the US printed a very strong 4.2% growth in the second quarter. At the same time, we have seen weaker data in Europe and in China which, together with trade tensions, renewed market concerns about the Chinese growth outlook. In EM outside of China, growth has been weaker than we expected which, in addition to several country-specific risks, has caused significant underperformance in EM assets against our expectations.
… to renewed growth convergence …
We now think this exceptional period of US outperformance is largely behind us. The US benefitted from strong fiscal policy support in the second quarter, which is likely to fade over time. Meanwhile, growth in Europe appears to be stabilising at a lower but more sustainable level than we saw late last year. The recovery in Japan, which had been more muted than we expected, is gradually continuing. In China, policy support has been firm in the face of weaker data and risks from trade, which we think will eventually generate a period of positive surprises. Outside of China, most EM countries have healthy economic fundamentals and should benefit from US growth. In our view, the weakness in EM assets reflects country-specific challenges rather than a broad EM crisis, and the bigger picture is one of global growth converging at healthy levels after a period defined by US exceptionalism.
… and continued consolidation of long end US rates
We expect some moderation in US growth and continued consolidation in the long-end of US rates to be important aspects of the macro environment towards year-end.
In the spring, we thought interest rate risk would return later this year after a period of consolidation in long-term rates. However, that consolidation now looks likely to continue until around the turn of the year. The market is pricing approximately 45 basis points of additional Fed rate hikes in 2018, suggesting markets will not be surprised if the Fed delivers the two hikes we expect. At the same time, inflation has been slow to firm, with the acceleration in year-over-year numbers this year largely reflecting base effects. With gradual inflation and a likely moderation in US growth, we think the Fed will want to keep its options open by waiting at least until the run-up to the December meeting to signal a more aggressive pace of rate hikes in 2019. We see plenty of signs of firming inflation, but we think it will take time before inflation becomes strong enough to impact monetary policy more significantly.
A challenging investment landscape to navigate …
We think the investment environment will remain challenging to navigate and we continue to favour a dynamic approach to investment. Trade and geopolitics are likely to be a continued source of volatility, and moderation in US growth could well lead to a temporary sell-off in US equities. We also worry about Italy's budget negotiations and the outlook for Italian growth. Despite these challenges, we think continued economic expansion and decent earnings growth will leave developed market (DM) equities higher by year-end. That said, we are less bullish on DM equities than we were earlier in the year as equities have recovered significantly. Also, while this update focuses on the rest of 2018, as we move into 2019 the risk to US growth becomes more nuanced as Fed policy continues to tighten while the impact of fiscal stimulus moderates further.
… but fertile for an EM Comeback
We think the recent US economic outperformance, combined with softer growth in many other economies, has been an underappreciated factor behind asset performance in general in recent months and EM underperformance in particular. We therefore see the shift to convergence—with US growth moderating while other economies stabilize as significant. We think EM assets will be the clearest beneficiary, supported by our view that market fears of trade tensions and EM contagion are likely to prove overdone. More generally, we would also expect the US dollar strength to start to fade.
- US exceptionalism has peaked
We think the period of diverging growth rates - driven by strong US outperformance is largely behind us. US growth benefitted from strong support from fiscal policy in the second quarter, which is likely to fade over time.
- Interest rates are likely to remain near current levels into year-end
We expect US interest rates to continue climbing over the longer term, but we see few catalysts for another significant move higher this year. With inflation rising gradually and US growth likely to moderate, we expect the Federal Reserve (Fed) to raise rates twice more in 2018, consistent with market pricing.
- A challenging investment environment, but fertile for an EM comeback
Trade tensions, political developments and the potential for a moderation in US growth raise the risk of a temporary pullback in equities later this year. However, we think US growth will remain above trend and economic fundamentals in most EM countries remain healthy, creating fertile ground for a comeback in EM assets.