Deutsche Asset & Wealth Management. Americas Edition June CIO View. Macro outlook. Flood of money continues

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1 Deutsche Asset & Wealth Management Americas Edition June 214 CIO View Macro outlook Flood of money continues

2 Growing divergence The United States is leading the economic way, followed by Japan and then the Eurozone. This could cause monetary policies introduced by central banks to move in different directions. Investors must keep this in mind when they make their decisions. In brief Randy Brown, co-chief investment officer The global economy remains on a solid growth track As a result of the cold winter, growth projections for the United States were lowered The United States has been leading the recovery since 29. Japan and the Eurozone are following Disparate growth is resulting in monetary policy divergence The continuation of tapering should strengthen the U.S. dollar For the United States, we are maintaining our 214 inflation forecast of 1.5 % In this low rate environment, money is likely to continue to flow into equities The global economy has just the right growth temperature. With inflation well under control, this is an environment where equities could continue to do well. Macro outlook Americas Edition June 214 2

3 Just the right temperature The global economy is growing at a healthy pace with no sign of either overheating or coming off the boil. Stock markets are rising as a result. But later this year there could be a growing risk of volatility Low inflation and solid growth these are the times when it could pay off to put money into equities. Among economists, such times go by the name of the Goldilocks economy. In the fairy tale, Goldilocks sampled three bowls of porridge. The first was too hot, the second was too cold, and the third one was just right. In other words, this means that the economy is neither too hot, a development that would stoke inflation, nor too cold, a trend that could lead to a recession. The world s major economic regions might now appear to find themselves in Goldilocks land: They are growing, but there is no sign that inflation will rise above inflation targets. The opposite actually appears to be true inflation rates are falling in the United Kingdom and the Eurozone. Only Japan is experiencing the return of inflation, thanks to the large previous devaluation of the yen as well as the consumption tax. (But, held back by anemic wage growth, inflation adjusted for the increase in consumption tax has not yet reached the Japanese government s target rate of 2 %.) In fact, the declining inflation in the Eurozone is fueling discussions about deflation risks. Accelerating global economic growth combined with moderate inflation these are arguably the two key factors likely to help equities. Randy Brown, co-chief investment officer Inflation rate trends Low inflation: Inflationary trends have been pointing downward in the United States and the Eurozone since the fall of 211. These trends have sent jitters about deflation running through markets. But the stable state of these economies suggests such concerns may be overdone. United States United Kingdom Japan Eurozone In % compared with previous year Dec 7 Dec 8 Dec 9 Dec 1 Dec 11 Dec 12 Dec 13 Macro outlook Americas Edition June 214 3

4 Long process of recovery The low level of inflation also suggests that the global economy will take a few more years to get back on its feet. Companies, private households and countries have indeed made progress in their efforts to cut their high debt levels. But the amount of debt being carried by economic actors in the world s leading economies is still too high when measured against economic performance, i.e. gross national product (GNP). Scaling back debt burdens is a drawn-out process and will weigh on investment and consumption for some time yet. The result: growth rates that fall short of long-term trends and low inflation rates. One impact is on the job market. Moderate economic growth only results in slow employment growth. This, in turn, curbs employees power to negotiate pay raises. So, in a circular way, low levels of wage growth make it more likely that inflation in all the major developed economies will remain weak this year and next year. There is also a third reason for meager price increases: falling commodity prices. Declining import prices for many commodities are causing inflation rates to fall in developed economies while boosting purchasing power. Low inflation The very low level of price increases in the industrial countries is due to moderate economic growth, low levels of wage growth and falling import prices. Even though inflation rates have been declining since the fourth quarter of 211, the recovery process has continued to move forward, and the economies of the developed world are producing solid growth. The United States is profiting most from the recovery, which followed the devastating economic crisis in 28 and 29. As trends in real GNP show, Japan and the United Kingdom are right behind. By contrast, the Eurozone has been a straggler, and its economy is just now starting to get out of the doldrums. One sign of increasing optimism is improving business climate indices for the Eurozone. Even in the face of the Ukrainian crises, the Eurozone Purchasing Managers Index (PMI) has hit its highest level in three years. The PMI now stands at 53.5 points, pulling it well above the 5 point threshold for expected positive growth. Balance-sheet trends Fast response: Central banks responded to the financial crisis in 27 by immediately cutting interest rates. In 28, they expanded the monetary base and thereby significantly expanded their balance sheets. By taking these steps, they prevented the global economy from being caught in a trap of deflation and recession. U.S. Federal Reserve Board Bank of England Bank of Japan European Central Bank Indexed: Beginning of 27 = 1 points Source: ECB, Fed, BoE, BOJ, Bloomberg Finance LP Jan 7 Jan 8 Jan 9 Jan 1 Jan 11 Jan 12 Jan 13 Jan 14 Macro outlook Americas Edition June 214 4

5 Don t worry about deflation Eurozone inflation trends do, however, still cast a shadow. The inflation rate s dip below the 1% level has prompted market players to begin worrying about sliding into deflation. But consideration of the underlying issues leads to a different conclusion: The decline in Eurozone inflation is primarily due to the temporary effect of falling import prices. This, in turn, has been triggered by declining energy prices and (until very recently) a surprisingly strong euro. The ECB has now acted to reverse euro strength and push up inflation to more acceptable levels. On June 5 it unveiled a range of monetary policy initiatives, both conventional and unconventional, and going beyond market expectations. The euro weakened sharply and so far has stayed down. One particular conundrum for the ECB, however, remains the divergence in inflation rates between Eurozone members. At one level, this must be a concern: even if the average Eurozone inflation rate moves up, economies with below-average inflation rates could still face deflation risks. But, at another level, regional deviations in inflation trends are welcome news. Falling production costs result in lower inflation in the periphery countries as well as in rising competitiveness. The differing levels of inflation signal that the adjustment process needed for economic recovery is intact and ongoing. Credit squeeze Companies in the south have particularly limited access to loans. This weighs on the development of commercial lending and the money supply. The European Central Bank (ECB) is using targeted longerterm refinancing operations (TLTROs) to ease the situation. As a result, we remain bullish about the Eurozone. We expect consumer prices in most peripheral countries to rise by the end of the year. For 214, we are sticking with our GDP growth forecast for the Eurozone of 1 %. Our inflation forecast is.7 % for 214. Development of gross domestic product Divergent growth: The rapid countermeasures introduced by central banks paid off. By 29, developed economies were growing once again. The United States led the way, with Japan and the United Kingdom following in its tracks. The Eurozone has been pulling up the rear, but it is now picking up speed. United States United Kingdom Japan Eurozone Q4 27 = 1 points Dec 7 Dec 8 Dec 9 Dec 1 Dec 11 Dec 12 Dec 13 Macro outlook Americas Edition June 214 5

6 Return of inflation Positive inflation outlook Market players also appear to be reasonably relaxed about deflation risk. A look at inflation expectations priced into the yields of inflation-linked and conventional bonds in the major markets shows that investors expect positive inflation rates in the next five years. It is also expected that consumer prices will rise again in Japan after two decades of deflation and stagnation. However, market players also do not expect inflation to rise to a level that would signal an overheating economy. In turn, these expectations serve as an indication that an increase in interest rates is unlikely this year. In Japan, the rise of inflation to 3.4 % in April was primarily caused by an increase in the consumption tax of 3 percentage points. Given the drastic size of the increase, many consumers moved up their purchases of durable consumer goods. As a result, consumption could decline in the second quarter. To offset this, the Tokyo government is planning to provide companies with a tax break. Long-term inflation expectations Positive expectations: The breakeven inflation rate is calculated from the difference in yield between conventional and inflation-linked sovereign bonds. This spread reflects the loss of interest the investor incurs for protection against inflation. At the moment, inflation expectations in major developed economies and industrial regions are positive. Benchmark interest-rate trends Expansionary monetary policy: As a result of moderate growth, low inflation rates and modest inflation expectations, it is unlikely that interest rates will be raised in the United States, Japan and the Eurozone this year. However, investors must expect the first moderate rate hikes by the Fed and the Bank of England in 215. Percent Percent Jun 1 Jun 11 Jun 12 Jun 13 Jan 7 Jan 8 Jan 9 Jan 1 Jan 11 Jan 12 Jan 13 Jan 14 United States* United Kingdom* Japan** Germany* * Long-range inflation expectations based on sovereign bonds with 5-year maturity; ** Long-range inflation expectations based on sovereign bonds with 4-year maturity United States United Kingdom Japan Eurozone Source: ECB, Fed, BoE, BOJ, Bloomberg Finance LP Macro outlook Americas Edition June 214 6

7 By the fourth quarter of 214, though, market players are likely to begin to price in an increase in U.S. interest rates. This could cause volatility in stock markets to increase. Because equities are not yet overpriced, these setbacks could serve as a good buying opportunity. It appears likely that the global economy will continue to have just the right temperature and that the Goldilocks economy will remain with us for some years to come, boding well for equities. Growing divergence The global economy has been getting back on its feet since 29. The United States has been leading the economic way. Japan and the Eurozone are following behind. This gives rise to expectations that monetary policies could move in different directions. In the third quarter of 215, the United States may take the first step and moderately increase interest rates. By contrast, we do not think that the ECB or the Bank of Japan are likely to raise their rates during the next three years. Yields of 1-year sovereign bonds Low interest rates: The declining trend in interest rates has caused bond prices to rise in recent decades. Yields in the four industrial countries have now dropped well below their long-range average from 199 to today. The low level of interest rates and the chance that rising yields could put pressure on bonds serve as arguments against long bonds. Price-to-earnings ratio of the S&P 5 Index Not overpriced: The S&P 5 Index has reached an all-time high. But the price-to-earnings (P/E) ratio has moved sideways during the past decade. The reason: Profits also rose. The current P/E ratio of the S&P 5 Index is near its long-term average from 199 to today. This indicates that equities are not overpriced. Percent Jan 9 Jan 95 Jan Jan 5 Jan 1 Jan 9 Jan 95 Jan Jan 5 Jan 1 United States United Kingdom Japan Germany S&P P/E ratio* Long-range average** Long-range average yields from 199 to May 214: USA = 4.99 %; Germany = 4.79 %; Japan = 2.37 %; United Kingdom = 5.64 % * Based on profit outlooks for the current financial year **Based on data from January 199 to May 214 Macro outlook Americas Edition June 214 7

8 Glossary Here we explain central terms from the Macro outlook Gross domestic product (GDP) is the value of all goods and services produced by a country s economy. Gross national product (GNP) is an economic statistic that measures what a country s citizens produced. It includes GDP plus any income earned by residents from overseas investments, but excludes income earned within the domestic economy by overseas residents Periphery countries (sometimes referred to as just the periphery) are those that are less developed than the core countries of a specific region Price-to-earnings ratio (P/E) compares a company s current share price to its per-share earnings The Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The S&P 5 Index tracks the performance of 5 leading U.S. stocks and is widely considered representative of the U.S. equity market. Macro outlook Americas Edition June 214 8

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