A new tune for 2018
Synchronicity has made a comeback this year, 34 years after topping the pop charts. Investors are touting a somewhat flimsy theory about global growth and equity returns, but we’ll be watching more convincing charts in 2018.
Ten years on from the deepest financial crisis to scour the West since the Second World War, volatility has all but disappeared from equity markets. The global equity benchmark is basking in the third longest period without a 20% correction since the 1970s. No daily setback has been greater than 1.5% since September 2016 – unprecedented since 2006. As we enter 2018, we ask: are investors right to be so sanguine?
The last two years of low inflation, easy money and healthy profits have been an investor’s dream. Governments even relented on austere fiscal policies (apart from the UK, of course, despite the fact it is less indebted than most). We don’t expect to awake from this dream with a jolt, but we cannot risk sleeping on the job.
In short, we do not expect equity returns to be as good as 2017 (global equities delivered 16%, marking the third-best year since the current cycle began in 2009). We expect earnings to be supported by decent – if still unremarkable – economic growth, meaning equities should satisfy most investors’ required returns.
Yet, we are especially vigilant for signs that growth won’t be strong enough for tightening monetary and financial conditions. Judging by both central bank rhetoric and our favoured leading indicators, this question may come to the fore around the middle of 2018.
Indeed, we believe monitoring the trade-off between growth and monetary policy will be the single most important job for investors as the year unfolds. For as we’ve written before, business cycles don’t die of old age. They die of sclerosis, as returns on capital get squeezed by the cost of raising that capital in debt or equity markets.
Turn that curve upside down
It is for this reason that so many analysts monitor the ‘yield curve’, a graph which plots the yield of government bonds from those maturing within months to those maturing in 30 to 50 years or beyond. This creates a line that usually curves upward because you expect a greater return for locking your money away for longer. Because firms tend to borrow at shorter maturities to fund long term projects, the yield curve can be used to gauge the onset of economic sclerosis. When economic growth starts to falter and recession looms, this curve inverts: long-term debt offers lower yields than short-term.
The difference between the yield of the 10-year and 1-year treasury bonds has turned negative, on average, nine months before the last nine US recessions. There has been only one false signal, way back in 1967! This nine-month lead is a boon to asset allocators, for equity markets tend to lead the economy by rather less time (offering a window to adjust portfolios before share prices are affected). Recently, the yield curve has become ‘flatter’ – in other words, the difference between long-term and short-term yields has become smaller. This has worried some investors. We feel that worry is premature: the curve is still a comfortable 1 percentage point away from inversion.
Further, it’s not the only quick check on the gap between the return on capital and the cost of capital. You can also measure the gap between GDP growth and interest rates. Based on independent forecasters’ estimates for GDP growth in 2018 and the path of interest rates projected by the Federal Reserve (Fed) rate-setting committee, this gap is likely to remain positive next year (even if the Fed raises rates one or two more times than the three they currently indicate). This should provide some support for equity markets as the Fed tightens.
It is also important to note that global monetary conditions are barely tightening at all as yet. Of the 21 central banks we monitor, only four have raised rates over the last 12 months, while five are still cutting. Extraordinary monetary policy will remain supportive too: aggregating the paths signalled by the Fed, the European Central Bank, the Bank of England and the Bank of Japan, central bank balance sheets won’t start to shrink (along with the amount of money they have pumped into the marketplace) until 2019 either. Furthermore, credit spreads (the extra return for risk of default) have continued to shrink and mortgage rates have continued to fall in many countries. This means broader financial conditions, which take into account not central bank rates of interest but those actually available to firms and households – arguably more important to stocks – are actually still loosening.
Still, we do not expect conditions to remain so easy. We are not looking for any dramatic jump in wages or consumer prices to drive this change: just enough inflation for central banks to justify the paths they are already indicating (explicitly or implicitly). There is little evidence to suggest that the Phillips Curve – the inverse relationship between unemployment and inflation – is shaped like a hockey stick. That is, we don’t think inflation is set to spike as unemployment remains low. At the same time, we don’t believe that the world is profoundly deflationary either, as elaborated in our recent report on the drivers of inflation . Ageing is likely to be inflationary from now, albeit modestly. Meanwhile, globalisation is in the doldrums and its net effect on prices hasn’t actually been all that deflationary when you factor in the impact the developing world’s booming middle class has had on the price of food, commodities and other goods. Even the ‘Amazon effect’ of cut-throat ecommerce hasn’t reduced prices as much as you might think.
As interest rates continue to rise over 2018, the most optimistic investors will argue that the tightening cycle is still relatively unadvanced compared with previous episodes. But GDP growth has been comparatively low. If we adjust the change in the federal funds rate for US GDP, for example, today’s cycle does not look nearly so young in comparison.
What about the UK?
Some of you might be thinking why all of this matters when the Bank of England has said that it will raise UK rates only another two times before 2020. It matters because we are global investors. Even a portfolio consisting of just the FTSE 100 index earns around four-fifths of its revenues overseas. The old adage, ‘if America sneezes the UK catches a cold,’ is applicable to the stock market more than anything.
Growth in the UK is likely to remain weaker than in any of its G7 peers. Real wages have been falling since February, and even employment fell in the three months to the end of October. The absence of a resurgent business investment cycle – currently enjoyed globally – and depressed surveys of firms’ investment intentions suggest a weak outlook. The tortuous Brexit negotiations are likely to continue in the same manner in 2018, which won’t help investment appetite and growth. Theresa May’s Government is looking weaker by the day, leading to greater risk of another election and a potentially radical change in UK policy.
Turning to global growth, many commentators are talking – dare we say a touch platitudinously– about the concept of ‘synchronised growth’. Certainly, almost all of the world’s 25 largest economies are on track to grow next year, but then almost all of them did that this year too. When we interrogate the idea of synchronised growth, it doesn’t appear to us that 2018 is likely to be unusually synchronous or that stock markets will consequently enjoy outsized returns.
Synchronicity is unlikely to mean the number of economies growing, full stop. Outside of recessions, the vast majority of the world’s larger economies grow all of the time. More meaningfully, it should refer to the proportion of economies with above trend or average rates of growth (what we call a positive ‘output gap’) or the proportion of economies with an increasing annual rate of growth (what we call ‘acceleration’). Currently, around two-thirds of the world’s 25 largest economies are growing above their long-run trend; based on the IMF’s forecasts for 2018 that’s not likely to change much next year. Similarly, two-thirds are on track to achieve a higher rate of growth in 2017 than 2016, but the IMF believes that’s likely to decrease to around one-third in 2018.
There is a strong, positive correlation between the proportion of countries growing above trend and global equity earnings growth. This should mean that growth is well supported next year, but not to any extraordinary degree. Unfortunately, there is no correlation with the rate at which those earnings are discounted into today’s price, which means there is no relationship between synchronicity and equity returns. That’s not surprising, because strong earnings growth in the latter stages of the business cycle often coincides with rising interest rates as central banks look at an effervescent economy, worry about inflation bubbling over and attempt, often heavy-handedly, to skim off the froth.
Go West, young man
The US is among the minority of major economies likely to grow at a faster rate in 2018 than in 2017. But it’s an important one! Wage growth will likely remain constrained, but enough should be eked out to maintain consumer confidence. Crucially, businesses are investing more, as they often do when central banks first start to tighten interest rates. And judging by the leading indicators, that’s set to continue. Stocks more oriented towards business investment than consumer spending have outperformed recently and this is likely to continue.
This will no doubt be boosted by the tax policies of the Trump administration, but only modestly. As we write, both chambers of Congress have passed their own versions of legislation to cut taxes. Although the reconciliation process will not be straightforward, we expect tax cuts to pass given the relative ease with which dissident Republican congressmen and women in the House and Senate have been brought round so far.
To understand why the boost is likely to be modest, we must discuss a concept called the ‘fiscal multiplier’. This quantifies how much economic activity is likely to result from every dollar of tax cut. Multipliers from the new legislation are likely to be towards the lower end of the historic range: perhaps 30-40 cents on the dollar for corporate measures due to already high levels of investment and disincentives to invest in R&D and take out new loans; 20-30 cents for personal income due to the stark skew towards the wealthiest tax payers, who tend to save most windfalls. The most sophisticated estimates of what the proposed tax cuts will do to growth in 2018 suggest around an extra 0.3% of GDP growth. That may be in the price already. Analysts revised up their forecasts for 2018 GDP growth by 0.2% when Trump was first elected, and by another 0.1% after the House passed their tax bill on 16 November.
Remember that markets do best in periods of moderate economic growth, low(ish) inflation and easy money. The Trump agenda seems likely to boost demand a touch in the short term, but do little for the economy’s long-term productive potential. That may actually expedite the economy’s transition from expansion to slowdown in 2019, by provoking the Fed to raise rates to stave off inflation, thereby squeezing the cost of capital without any accompanying increase in long-run returns.
Wait and Xi
We expect emerging market equities to have another strong year, even though the Chinese economy may soften as a result of financial tightening, a weak property market and industrial restrictions to curb pollution. Contrary to popular wisdom, emerging market equities have previously outperformed during past Fed rate tightening cycles. We expect this to recur unless their currencies start to weaken significantly.
We are much more sanguine than many of our peers about the level of debt in China and its neighbours. For sure, we expect that past excesses will reduce new growth and lending to productive projects for years to come. But China is not your typical emerging market ‘basket case’ and the risk of a debt crisis is not worryingly high, in our opinion.
First, most of China’s debt is funded with domestic capital and so questions over debt sustainability do not translate into a balance of payments crisis, like those experienced in Asia in the late 1990s (capital controls also help, of course!). China is still a net lender to the rest of the world, with a gross national saving rate of 45% (10-20% is the norm in developed markets).
Second, loans from domestic banks are largely funded with deposits. Remember, one of the causes of the global financial crisis in the West was that bank loans greatly exceeded deposits. The shortfall was plugged by fickle interbank loans, which are more likely to be withdrawn in a hurry than household savings accounts. In China the debt to deposit ratio is just 80%, compared to about 125% in the US during the financial crisis. Indeed, in April, the Chinese regulator banned banks from obtaining more than a third of their funding from interbank lending.
Third, most of China’s debt has been issued by state-owned banks to state-owned firms and local government entities. Defaults can be averted by shifting money from the left pocket to the right pocket. In our 2015 report, Taming the dragon: the long-term outlook for China’s economic growth, we presented an extreme hypothetical scenario in which default and recovery rates were far worse than those experienced in any debt crisis anywhere in the world over the last 40 years. If the government were to expropriate the bad debt from this scenario on to its balance sheet in one big, overnight clean-up, its debt to GDP ratio would still be lower than that of most G7 members.
Tech: there’s a multiple for that
Both US and Asian equity benchmarks have benefited from booming technology sectors. Software and IT service companies now account for 14% of the S&P 500 (up from 9% five years ago) and 8% of the Asian benchmark excluding Japan, up from just 3% five years ago. Their rise has been so propulsive it has precipitated a new acronym for their biggest players: the BAT-FAANGS, formed from the first letters of China’s behemoths Baidu, Alibaba and Tencent, and the US’s Facebook, Amazon, Apple, Netflix and Google.
Comparisons to the dot com boom are too crude. Yes, valuations are very high, but they are not stratospheric and they are already underpinned by proven formulae for generating billions of dollars of revenue. Analysts expect US tech sector earnings to grow 13% in 2018, compared to 10% for global equities in general. That’s a high bar, but not one that is likely to come down with a crash. Technology stocks and the broader equity market rally have propelled price/earnings ratios to levels that some investors believe could herald a fall. Fortunately, valuations are a terrible market-timing tool. There is simply no correlation between PE multiples and prospective returns over the following 12 months. Even when valuations have been in the most expensive decile (they are within a whisker of that at the moment), stocks have been as likely to go up as they have been to go down over the ensuing year. Furthermore, when it comes to asset allocation, investing in the countries with the lowest PE multiples has been a recipe for underperformance for the last decade.
Far from the madding crowd
For now, we continue to favour equities over bonds. We particularly prefer under-owned markets that are most likely to exceed earnings expectations – such as Japan or wider Asia.
Next year is unlikely to usher in the end of the good times, but the peak in economic growth rates is probably behind investors now. Greater volatility could rattle markets, but it shouldn’t affect economic growth.
In the meantime, we will be watching the gap between the returns on capital and its cost.