Global Economic Perspective

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1 Investment Team Update June 2017 Global Economic Perspective PERSPECTIVE FROM THE FRANKLIN TEMPLETON FIXED INCOME GROUP Christopher Molumphy Michael Materasso Roger Bayston John Beck David Zahn IN THIS ISSUE: US Economy s Rebound on Track, but Inflation Takes a Pause Oil Price Volatility Overshadowed by Gulf Political Crisis Lower Inflation Forecasts Support ECB s Continued Dovish Stance US Economy Set to Rebound on Track, but Inflation Takes a Pause The US economy s performance thus far in the second quarter looks on track to return to its pattern of moderate expansion, in our view, reversing the softness seen at the beginning of The robust foundations provided by labor, housing and financial market strength remain in place, supported by the post-election improvement in consumer and corporate confidence, even if this economic cycle is unfolding in a different way than previous ones. Up to now, and for reasons that are yet to be fully understood, the labor market has not produced any noticeable increase in wage inflation, though it appears close to full employment. Although we are cognizant this weaker correlation between employment and wages may persist for some time, if the labor market continues to tighten, then it seems likely to us the historic pattern of higher wages feeding into broader inflation seen in past economic cycles will eventually reassert itself, allowing the Fed to move closer to the normalization of monetary policy. The second reading of first-quarter US gross domestic product (GPD) growth, which saw the initial annualized rate of 0.7% revised up to 1., helped to ease concerns about the sluggish start to the year, as did ongoing questions about the impact of seasonality on growth statistics. But more compelling evidence that the US economy could be regaining its footing came with April s consumption report, in which consumer spending posted a respectable gain of 0. month-on-month, while March s figure was amended from unchanged to a rise of 0.3%. Reassured by such data, most estimates for second-quarter growth predicted a solid rebound back above the trend rate that has been characteristic of the US economy in recent years, with some outliers projecting a sharper acceleration to over 3%. In our view, the US economy looks on track to return to its pattern of moderate expansion. The labor market report for May showed additional hiring of 138,000, around 50,000 below consensus expectations, and also included a sizable reduction in April s strong jobs gain. Nevertheless, the unemployment rate continued to move lower, with the reading of 4.3% marking the lowest level since 2001, while measures of labor participation and underemployment declined as well. In keeping with the pattern that has generally prevailed as the labor market has tightened during the current economic cycle, there was little sign of a sustained build-up in wage pressures in May s report, even though April s personal Not FDIC Insured May Lose Value No Bank Guarantee

2 income release had shown an outsized gain in wages and salaries. Average hourly earnings ticked up 0. month-onmonth with April's reading revised down to the same level to leave the annual rate unchanged at 2.5%. Little Sign of Mounting US Wage Pressures Exhibit 1: US Average Hourly Earnings, % Annual Change January 31, 2014 April 31, % 2.6% % 1.6% /14 05/14 09/14 01/15 05/15 09/15 01/16 05/16 09/16 01/17 05/17 Source: FactSet, Bureau of Labor Statistics Elsewhere, a survey comparing job openings with hirings underlined the strong demand for workers, as well as the difficulties facing companies in their efforts to recruit employees with the appropriate skills. The Job Openings and Labor Turnover Survey report covering April found openings had risen sharply from the previous month to more than 6 million, while hirings shrunk to just over 5 million, leaving the spread between the two nearly 150,000 higher than in March. Broader inflation data maintained a recent trend of softer-thanexpected readings. Though the Fed s favored measure the core personal consumption expenditures (PCE) price index posted a 0. rise month-on-month in April, the annual rate fell 0. to 1.5%, its lowest level since December The equivalent annual headline PCE figure showed an even larger drop, down by 0. to 1.7%. The current absence of inflation pressures was also apparent in consumer price indexes, which registered similar falls at the core and headline level over the same period, to 1.9% and 2. respectively. However, minutes released from the Fed s meeting in May revealed that policymakers were relatively sanguine about the softer inflation data, seeing the dip as primarily reflecting transitory factors, such as lower cell phone charges. Citing the need for a further removal of some policy accommodation soon, as long as economic data came in as expected, the minutes reinforced sentiment among market participants about the probability of another increase in interest rates at the Fed s next meeting, which was duly confirmed by policymakers in mid-june. But sentiment about the path for monetary policy for the rest of the year was less certain, and in the run-up to June s meeting, market participants were more or less evenly split about whether interest rates would rise again during the year. Even though US interest rates appeared set to rise, the US dollar lost ground for the third consecutive month, ending May at its lowest level on a trade-weighted basis since the US presidential election. The move in the dollar was partly explained by the ongoing strength of the euro, which has rallied strongly since the start of the second quarter on speculation about a potential tapering of bond purchases by the ECB. US Treasury yields also drifted toward the bottom of their trading range for the year to date, amid fresh political problems surrounding the Trump presidency and heightened concerns about its abilities to effectively implement policy. Despite the administration s missteps, we still view its policy stance as likely to enhance growth for example, through deregulation even if the timeline for its more ambitious fiscal programs seems to be stretching further into the future. In our view, it is important to remember that prior to the presidential election, benchmark Treasury yields were around 40 basis points lower, indicating it is not just equity markets that believe the election s outcome has improved the outlook for economic growth. Oil Price Volatility Overshadowed by Gulf Political Crisis Oil prices had another volatile month, peaking in mid-may as the Organization of the Petroleum Exporting Countries and other major oil producers agreed on a deal to extend existing production cuts for another nine months. But disappointment that the cuts had not been extended for a longer period, combined with expectations that US shale oil production would continue to add to global supplies, soon saw oil prices come under renewed pressure, hitting their lowest levels of the year so far by early June. Oil s losses occurred despite the sudden outbreak of a political crisis in the Persian Gulf, as a group of countries, led by Saudi Arabia and the United Arab Emirates, broke off diplomatic relations and transport links with Qatar. One of the world s largest producers of liquefied natural gas, Qatar has long used its significant energy-derived wealth to pursue an independent political path, particularly in terms of its support for various Islamist groups across the Middle East that have been widely viewed as threats by the rulers of many other Arab countries. Qatar s recent opening up of ties with Saudi Arabia s main rival Iran may have been one of the triggers for the rupture in relations between the fellow members of the regional Gulf Cooperation Council. Elsewhere, South Africa s economy unexpectedly moved into recession, after a contraction in the final quarter of 2016 was Global Economic Perspective 2

3 followed by a decline of 0.7% quarter-on-quarter over the first three months of The economy s weakness at the start of the year came as a surprise as consensus forecasts had predicted growth of around but was broad-based, affecting all sectors except agriculture and mining. The subsequent period has seen further problems, with an upsurge of political concerns due to the sacking of the country s respected finance minister by President Jacob Zuma, which led Standard & Poor s to cut South Africa s credit rating to one level below investment grade. However, rival rating agency Moody s decided against such a move, arguing that South Africa s strengths such as low levels of foreign-currency debt, deep domestic markets and a well-capitalized banking sector went some way toward offsetting its political and economic problems. Brazil Finally Emerges From Recession Exhibit 2: Brazil GDP, QoQ % March 31, 2014 March 31, % % % % % 03/14 09/14 03/15 09/15 03/16 09/16 03/17 Source: FactSet, Instituto Brasileiro de Geografia e Estatistica By contrast, Brazil exited its deepest-ever recession in the first quarter, with growth of compared to the previous three months marking an end to eight consecutive quarters of contraction. The turnaround was mainly due to an outsized soybean harvest, but similarly to South Africa, did not capture the impact on the economy of the country s most recent political crisis, which initially appeared to threaten the position of President Michel Temer. The current president only came to power in 2016, after the previous incumbent was impeached for budgetary irregularities. Although President Temer survived a ruling by Brazil s electoral court, which potentially could have removed him from office, questions remained over his ability to see through a program of labor and pension reforms, which is widely viewed as essential to bridge the country s budget deficit of over 9% of GDP. Though political problems in South Africa and Brazil continue to mount, the notion that such risks are predominantly confined to emerging markets has been disputed by the upheavals in the political landscape across Europe and the United States since the global financial crisis. Some market participants might argue that recent electoral results indicate the high-water mark of populism (and its potential to induce political upsets) has been reached, but we believe whichever markets investors are considering, it is increasingly important for them to recognize the influence of politics on economic fundamentals. Lower Inflation Forecasts Support ECB s Continued Dovish Stance Updated GDP data revealed that the eurozone s first-quarter growth was a little better than first thought, with the numbers revised up from 1.7% to 1.9% year-on-year, as the performance of the French, Italian and Greek economies improved. The strength of a leading manufacturing survey for the region, which hit a six-year high in May, suggested the pickup was likely to extend into the second quarter. Indeed, the employment component of the survey reached a record level, raising hopes for further job creation across eurozone economies, many of which still have significant slack in their labor markets. However, the latest inflation data showed regional price pressures remained subdued, easing to an annual rate of 1. in May at the headline level. The ECB s June meeting broadly reflected these trends in growth and inflation. The central bank s updated forecasts for annual growth up to 2019 were each bumped up by 0., but it continued to envisage a slight slowdown, from 1.9% for the current year to 1.7% in Some of its corresponding inflation numbers, however, received a larger downward adjustment, with the forecast for 2018 cut from 1.6% to 1.3%, while the estimate for 2019 saw a more modest reduction from 1.7% to 1.6%. Given the weak inflation outlook, it was little surprise the ECB resisted calls for an announcement regarding when it would begin to taper its bond-purchasing program, with ECB President Mario Draghi We think it s important for investors to recognize the influence of politics on economic fundamentals. emphasizing the continued need for a very substantial degree of stimulus to support stronger inflation. Nevertheless, the central bank updated its forward guidance by dropping a reference to further cuts in interest rates if warranted, a move President Draghi subsequently confirmed as signifying policymakers were no longer worried about a potential slide into deflation. We are encouraged that the ECB has again resisted calls to signal a tapering of its quantitative easing program. By stressing the time potentially needed to reach its inflation target of close to, the central bank has underlined that Global Economic Perspective 3

4 European Central Bank Cuts Inflation Forecasts Exhibit 3: European Central Bank Inflation Forecasts for As of March 31, 2017 and June 30, % 1.6% % 0.6% Source: European Central Bank Previous ECB forecast (March 2017) Latest ECB forecast (June 2017) while the current recovery may be broadening, its momentum is not yet self-sustaining, and that the risks from a premature removal of monetary stimulus still far outweigh the possibility of a surge in prices due to an overly loose monetary stance. The outcome of the UK general election produced yet another political upset, as the ruling Conservative party lost its parliamentary majority. UK Prime Minister Theresa May had sought a fresh mandate from voters, principally to strengthen her authority during forthcoming Brexit negotiations on the terms of the United Kingdom s departure from the European Union (EU). But despite a strong Conservative lead in the polls at the start of the campaign, the result produced a hung parliament, with no single party having a majority, forcing Prime Minister May to seek to form a minority government with the support of a small party from Northern Ireland. The first round of France s parliamentary elections pointed to an eventual sizable majority for French President Emmanuel Macron s fledgling En Marche party, which fielded parliamentary candidates for the first time. A majority in the French parliament was seen as essential for President Macron to carry out his proposed reform program, centered on the labor market and welfare system, and aimed at halting any further deterioration in the country s economic fundamentals. Two major concerns in France a high debt-to-gdp ratio and a sizable budget deficit have generally been uppermost in investors minds. President Macron has said he is committed to meeting EU rules and reducing France s deficit below 3% of GDP, but this has seemed somewhat at odds with his other promises to boost some areas of public spending. In Spain, after concerns about a capital shortfall (resulting from non-performing real estate loans) had triggered a run on the deposits of one of the country s medium-sized lenders, the bank was sold to a larger competitor for a nominal sum. The demise of the Spanish lender marked the first time the new European system for unified banking supervision had been employed since its establishment more than two years ago, with eurozone officials stepping in to take control of the bank after declaring it failing or likely to fail. Although holders of the bank s shares and junior bonds lost their investments, the rapid resolution and lack of contagion from the situation was widely judged to be a successful outcome for European financial regulators. We think the UK election result could increase demands for greater transparency during Brexit negotiations. The UK election result has clearly increased political uncertainty but, in our view, could also increase demands from the UK parliament for greater transparency during the Brexit negotiations, which are due to begin shortly. A weakened minority Conservative administration would also seem more vulnerable to the possibility the UK parliament could reject an unpopular Brexit deal. Indeed, the greater the parliamentary demands and constraints on the UK government during its negotiations, the more likely we anticipate a hard Brexit scenario to be particularly if EU negotiators are emboldened to take a tougher line potentially leaving the United Kingdom without a deal to replace the current European trade agreements. Global Economic Perspective 4

5 EUROLAND MACROECONOMIC DATA FINAL OUTPUT Gross Domestic Product (GDP) 1 2Q16 3Q16 4Q16 1Q17 GDP, Y/Y (%) Private Consumption, Y/Y (%) Gross Fixed Capital Formation, Y/Y (%) ECONOMIC INPUTS 1 JAPAN MACROECONOMIC DATA FINAL OUTPUT Gross Domestic Product (GDP) 4 2Q16 3Q16 4Q16 1Q17 GDP, Q/Q ar (%) Private Consumption, Q/Q ar (%) Fixed Capital Formation, Q/Q ar (%) ECONOMIC INPUTS Abbreviations: Q/Q ar: Quarter-over-quarter annualized rate. Y/Y: Year-over-year. 1. Source: European Union Source: Bloomberg. P/E ratios of Dow Jones EURO STOXX 50 Price Index and Nikkei-225 Stock Average as calculated by Bloomberg. 3. Source: European Central Bank. 4. Source: Economic and Social Research Institute, Cabinet Office, Government of Japan. 5. Source: Ministry of Internal Affairs & Communication, Japan. 6. Source: Ministry of Economy, Trade and Industry, Japan. 7. Source: Ministry of Finance, Japan. 8. Source: Bank of Japan. 9. Source: Bloomberg Indexes. For Past Financial performance Professional does not guarantee Use Only future / results. Not For Public Distribution Jan 17 Feb 17 Mar 17 Apr 17 Unemployment Rate (%) Industrial Production, Y/Y (%) Tertiary Index, Y/Y (%) Corporate Activities 2Q16 3Q16 4Q16 1Q17 Corporate Profit Growth (%) Tankan Quarterly Survey (index level) INFLATION Inflation Indicators 5 Jan 17 Feb 17 Mar 17 Apr 17 Consumer Price Index (CPI), Y/Y (%) CPI ex Fresh Food, Y/Y (%) FINANCIAL MARKETS 2 Feb 17 Mar 17 Apr 17 May 17 Nikkei 225, Trailing P/E Ratio Month Yield JGBs (%) Year Yield JGBs (%) BALANCE OF PAYMENTS Jan 17 Feb 17 Mar 17 Apr 17 Retail Sales, Y/Y (%) Unemployment Rate (%) Industrial Production, Y/Y (%) INFLATION & WAGE PRESSURE Inflation Indicators 1 Feb 17 Mar 17 Apr 17 May 17 Consumer Price Index (CPI), Y/Y (%) Core CPI, Y/Y (%) FINANCIAL MARKETS Dow Jones EURO STOXX 50 Price Index EUR, Trailing P/E Ratio 2 Feb 17 Mar 17 Apr 17 May ECB Refinance Rate (%) Year Yield German Bunds (%) BALANCE OF PAYMENTS 1, 3 Trade Balance Dec 16 Jan 17 Feb 17 Mar 17 Billion Euro Current Account Balance 2Q16 3Q16 4Q16 1Q17 % GDP Monthly Trade Balance 7 Jan 17 Feb 17 Mar 17 Apr 17 Billion Yen Current Account Balance 9 2Q16 3Q16 4Q16 1Q17 % GDP Eurozone Real GDP, Y/Y - - Source: European Union , as of March Consumer Price Index, Y/Y 3% - 5/12 5/13 5/14 5/15 5/16 5/17 CPI Core CPI Source: European Union , as of May External Trade Balance, GDP 3% 1Q14 1Q15 1Q16 1Q17 Source: European Union , as of March Japan Real GDP, Q/Q ar 1 8% - -8% Source: ESRI, Cabinet Office, Government of Japan, as of March Consumer Price Index, Y/Y - 4/12 4/13 4/14 4/15 4/16 4/17 CPI CPI ex Fresh Food Source: Ministry of Internal Affairs and Communications, Japan, as of April Visible Trade Balance, GDP % - 1Q14 1Q15 1Q16 1Q17 Source: Ministry of Finance, Japan and Economic and Social Research Institute, Cabinet Office, Government of Japan, as of March Global Economic Perspective 5

6 US MACROECONOMIC DATA FINAL OUTPUT Gross Domestic Product (GDP) 2 4Q16 1Q17 2Q17E 1 3Q17E 1 Q/Q ar (%) ECONOMIC INPUTS CONSUMPTION/FINAL DEMAND Income/Savings 2 Jan 17 Feb 17 Mar 17 Apr 17 Consumer Spending, Y/Y (%) Personal Income, Y/Y (%) Savings Rate (%) Employment Feb 17 Mar 17 Apr 17 May 17 Unemployment Rate (%) Participation Rate (%) Nonfarm Payrolls (in thousands) Jobless Claims, 4-wk average (in thousands) 4 Housing 5 Jan 17 Feb 17 Mar 17 Apr 17 Existing Home Sales (in millions) Y/Y Change (%) INVESTMENT Corporate Earnings 6, 11 4Q16 1Q17 2Q17E 3Q17E Earnings, Y/Y (%) Production & Utilization 7 Jan 17 Feb 17 Mar 17 Apr 17 Industrial Production, Y/Y (%) Capacity Utilization (%) Nonresidential Fixed Investment 2 2Q16 3Q16 4Q16 1Q17 Y/Y (%) INFLATION & PRODUCTIVITY Inflation Indicators Feb 17 Mar 17 Apr 17 May 17 Personal Consumption Expenditure (PCE), Y/Y (%) Core PCE, Y/Y (%) Consumer Price Index (CPI), Y/Y (%) Core CPI, Y/Y (%) Producer Price Index (PPI), Y/Y (%) Core Producer Prices, Y/Y (%) Productivity 3 2Q16 3Q16 4Q16 1Q17 Productivity, Q/Q ar (%) Unit Labor Costs, Q/Q ar (%) FINANCIAL MARKETS Valuation May 17 June 17 July 17E Aug 17E P/E S&P Fed Funds Rate 7, BALANCE OF PAYMENTS US Monthly Trade Deficit 2, 9 Jan 17 Feb 17 Mar 17 Apr 17 Billion USD US Current Account Deficit 1Q16 2Q16 3Q16 4Q16 Quarterly (in USD billion) Annualized (% GDP) Abbreviations: Q/Q ar: Quarter-over-quarter annualized rate. Y/Y: Year-over-year. E: Estimate. 1. Source: Bloomberg Economic Forecasts as of 5/31/ Source: Bureau of Economic Analysis. 3. Source: Bureau of Labor Statistics. 4. Source: Department of Labor. 5. Source: Copyright National Association of REALTORS. Reprinted with permission. 6. Source: Standard and Poor s. 7. Source: Federal Reserve. At the 6/14/17 meeting the Federal Reserve raised the main US interest rate to a target rate between 1.0 and 1.25%. 8. Source: Chicago Board of Trade (30-Day Federal Funds Futures Rate for July 2017 and August 2017), as of 6/15/ Source: US Census Bureau. 10. Source: Bloomberg Indexes. 11. Source: Bloomberg calculations are share-weighted y/y. Estimates as of 6/9/17. Gross Domestic Product (GDP), Q/Q ar 6% - - Source: Bureau of Economic Analysis, as of March Personal Income & Expenditures, Y/Y 1 8% - 4/12 4/13 4/14 4/15 4/16 4/17 Consumer Spending Personal Income Source: Bureau of Economic Analysis, as of April Nonfarm Payrolls & Unemployment Rate Thousands /12 5/13 5/14 5/15 5/16 5/17 Nonfarm Payrolls Net Change Source: Bureau of Labor Statistics, as of May All figures seasonally adjusted. Consumer Price Index, Y/Y Source: Bureau of Labor Statistics, as of May Productivity & Unit Labor Costs, Q/Q ar Source: Bureau of Labor Statistics, as of March US Annualized Trade Deficit, GDP Percent 1 1 8% 6% Unemployment Rate (Right-Hand Scale) 3% - 5/12 5/13 5/14 5/15 5/16 5/17 15% 1 5% -5% % % CPI Core CPI Unit Labor Costs Productivity -4. Source: Census Bureau and Bureau of Economic Analysis, as of March For Past Financial performance Professional does not guarantee Use Only future / Not results. For Public Distribution Global Economic Perspective 6

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