Investment Update Q3 2018
Clearing the hurdles
After a brief wobble, markets regain their pace.
Having briefly lost confidence around the time of our last quarterly update, markets are off to the races again – overcoming a number of obstacles along the way – even if the gallop has slowed to a canter in June.
Markets were roiled in late March by concerns that rising inflation was becoming problematic and interest rates were in danger of rising too far, too fast – especially in the US. If true, this would choke off the business cycle, so the danger sent equities lower. After careful analysis and considered debate, we concluded that the wobble was very unlikely to evolve into a thunderous crash. We thought markets would recover. In short, economic growth is still strong and inflation – despite the hyperbole of many commentators – is still relatively low.
In fact, the median rate of inflation (excluding the erratic prices of energy and food) across 22 of the most advanced economies is lower today than it was a year ago. In the US, under normal governmental spending, we estimate that borrowing costs will not start to hurt economic growth until interest rates reach around 2.5%. That would be consistent with a 10-year Treasury bond yield of about 3.5%. Today, that yield is around 2.9% so there’s plenty of headroom. And with President Donald Trump’s fiscal largesse the economy may be able to accommodate slightly higher rates still. In the UK and Europe, there is an even greater gap between today’s borrowing costs and where they would need to be to bring about the end of the cycle.
Since the end of the last quarter, major UK and US equity indices are up by between 5 and 10% in sterling terms. And that’s despite a series of further hurdles investors have had to overcome: the Italian political crisis, currency crises in a few emerging markets and escalating trade tensions between the US and China as well as Western allies, including Europe and Canada. We believe the first two issues are unlikely to flare up into global distress. We are much more concerned about the fallout of a trade war. Still, we think the chance of it tipping the world into recession over the next 12 months is pretty remote. This is more a case of dark clouds gathering on a distant horizon.
Tempest in an espresso cup
Many European stock markets, including the German DAX, have lagged the vast majority of markets across the globe so far this year.
Even before the Italian political crisis the bloc’s positive economic signals had faded. The growth of industrial production and new factory orders were slowing, while retailers had sobered up after year-end euphoria. Businesses were applying for fewer bank loans, a sign that they saw fewer decent prospects for expansion.
The reversal of Continental fortunes caught many off guard: investors expected strong economic data to continue. You can see the extent of this disconnect between hopes and reality in the Citigroup Economic Surprise Index, which measures the difference between economic forecasts and actual outturns. The European version of the index began 2018 at 50, meaning data were strongly beating expectations. It bottomed out in March at -101, the worst level of disappointment since 2011. Equity analysts’ earnings forecasts have now been revised down – in contrast to most other regions – and may need to go lower still.
Political turmoil then soured European sentiment further. The Sentix survey of economic expectations hit a six-year low when it was updated at the start of June. This is a volatile series, prone to overreaction, but other more stable leading indicators continue to point to a rate of growth slower than what we believe is priced into the market.
That said, we don’t believe that the Italian problem could morph into another regional debt crisis. Indeed, the brief wobble in Italy’s debt didn’t spread to other assets in ways that alarm us.
The architecture of the Economic and Monetary Union of Europe is very different today than it was during the eurozone debt crisis of 2011. Numerous backstops have since been implemented for countries that agree to play by the rules (the European Central Bank's ability to buy unlimited quantities of government bonds under the Outright Monetary Transactions programme and the European Stability Mechanism, for instance).
These backstops appear to be working: Spanish spreads (the extra return offered above German bonds) peaked at just a touch above their three-year average; at their worst, Portuguese 10-year debt still offered yields about half a percentage point less than US Treasuries. Even the spread of Italian bonds came nowhere near the giddy heights reached seven years ago. Yields for low-quality corporate debt stayed at a third of their 2011 levels and credit default swaps (a kind of insurance against a borrower failing to repay a bond) remained relatively cheap. This all tells us that people didn’t believe there was a high probability of Continental governments and companies reneging on their debts. Although European bank share prices have reached new lows relative to their American counterparts, the average yield on BBB-rated bonds issued by financial companies is 2.75%. During the 2011 debt crisis it reached 10%.
The economic outlook for Italy is bleak. No-one has the political capital to push for sorely needed reform. The policies of the new populist coalition will likely lead to a short-term boost in consumption before spiralling borrowing costs bring both the public and private sector crashing back down to earth. Such an environment would inevitably lead to some vocal and heated clashes with Brussels that the press will likely ham up. The resultant headlines will no doubt be strident and doom-ridden, which could well drive volatility and lower risk-adjusted returns.
If these episodes arise, it will be important to focus on the wider picture and determine whether the trouble is spreading to other nations. We will watch the yield on Spanish government debt with eagle eyes. Spain’s politics have served up a surprise new government too; however, some market commentators are misinterpreting the outcome. The new socialist Prime Minister has to govern with just 25% of MPs. The party in the ascendancy is the firmly pro-EU, pro-reform Ciudadanos, which has radical but centrist ideas. In fact, it’s a crying shame they’re not Italian. If they were, perhaps they would be able to implement the reforms Italy so badly needs.
Emerging markets: look to Asia
The Turkish lira and Argentine peso fell some 20% against the dollar between February and May, raising the question: are these localised events or precursors warning of more widespread disaster in the developing world?
We believe they are the former. Turkey and Argentina account for just 2.3% of global GDP between them. However, they remind us of the folly of chasing returns in unstable emerging economies: those loaded with debts in euros, pounds and dollars – currencies much stronger than their own – and run by governments failing to address acute problems that hold back growth. This is why we’ve avoided Latin America for a number of years.
Most large emerging economies in Asia are not, in our opinion, in states of precariousness. Many are still accumulating debts, but they are doing so at a much slower pace than the speed of their economic growth. Extensive academic studies tell us that it’s not the level of debt that increases the likelihood of a crisis, but the rapidity of its accumulation. Many have financial systems less reliant on flighty foreign capital and more on domestic deposits and other sources of funds. And most have healthier current accounts than they did in the 2013 ‘taper tantrum’ (when the US Federal Reserve signalled it would start tapering its quantitative easing). That was the last time investors really tested emerging market currencies. Happily, Asian emerging markets make up a much more significant share of global growth than LatAm and are home to many, many more companies.
We still like emerging market investments. The gap between the rate of GDP growth in emerging markets and developed markets is likely to widen this year, which tends to mean emerging market equities will outperform developed market equities. The key risk to this scenario is the outlook for the dollar: emerging market equities and debt have a long history of performing poorly when the dollar strengthens. We think the probability of an extreme dollar appreciation is low. On a long-term basis we consider the dollar overvalued. We come to that conclusion by looking at productivity, trading relationships, savings rates and differences in inflation.
America’s ballooning government spending deficit and the widening gap between imports and exports are likely to prove headwinds for the dollar. Even in an almost unthinkably optimistic scenario where US GDP growth reaches 3% and stays there for the coming decade, the US budget deficit will hover around 5% of GDP. The US needs to fund this deficit without hurting private investment. It could do this by running very tight monetary policy – thereby increasing the risk-free rate of return – but this would likely cause a recession. A better option is to slightly weaken the dollar and hope that foreign investors will want to buy US assets at more attractive prices. History suggests the US will plump for the latter.
Lots of heat, little light
The US tariff debacle, and the subsequent threats of retaliation from trade partners, continues to heat up. In addition to being potentially bad for consumers around the globe, the prospect of a global trade war is one of the biggest risks to longer-term investment returns. While protectionist measures in the 1970s and ’80s were met with appeasement; in today’s globalised world of trade retaliatory tariffs are a more likely outcome. A cloud of uncertainty hangs over international commerce. We’re keeping a close watch.
Invested but defensive
We aren’t ringing any alarm bells in this note, but please don’t mistake that for complacency.
We believe growth is still strong and inflation still low; but growth isn’t getting any stronger and inflation is likely to edge higher. In fact, countries with the lowest proportion of cyclical sectors (those most sensitive to the business cycle) have delivered the best returns so far this year, and vice versa. We remain invested, but right now we aren’t advocating the more-risky strategy of buying ‘cyclical’ assets.