Optimism with vigilance - investment update
Indicators point to a peak in the pace of global expansion, but we still prefer equities to bonds.
Ed Smith, Asset allocation strategist, Rathbones
Our favoured indicators tell us that the US and the global business cycles remain in an expansion phase. This is important as the performance of equities relative to bonds doesn’t tend to turn persistently in favour of the latter until the rate at which the economy creates jobs slows to a crawl. Today surveys of firms’ intentions to hire remain steady and ratios of job-openings to applicants continue to reach new highs in many parts of the world. Yet despite tight labour markets, we are noticing more and more pockets of falling real wage growth in developed markets: for example, in the UK (more below), in Italy and even in the US among part-time employees (which account for almost 1 in 5 jobs). This will temper growth in our consumer-driven economies.
Further, a number of our favoured leading indicators suggest global growth may reach an apex in the third quarter of the year. We expect growth to decelerate thereafter but, crucially, likely remaining comfortably above the recent trend for the rest of 2017. In particular, we note a mild increase in borrowing costs for firms and households. But not all borrowing costs are rising meaningfully, and certainly not to the extent that they are likely to lead to recession. Furthermore, borrowing conditions take about 18 months to affect economic output, while equity markets only tend to lead output by three. We’ll continue to monitor the data closely, as ever, but it’s not yet time for a wholesale shift away from equities.
Be careful of cyclicality
Still, as momentum in the global economy wanes, we re-emphasise the need for more cautious positioning. Investors are pouring money into Europe. In May, BlackRock iShares, the world’s largest ETF provider, registered $9.3bn of inflows into European equity funds, while $3.1bn flowed out of the US. However European markets contain a large proportion of cyclical industries – sectors with a high sensitivity to economic momentum – especially compared to the UK. European equity valuations are not cheap compared to their historic average or their historic ratio with other regional equity markets. They have surged over the quarter, almost converging on US valuations, without any improvement in return on equity – a measure of profitability relative to invested capital.
In most Western markets this year, we’re observing stocks that fall into the more defensive large-cap ‘growth’ category beating the racier ‘value’ opportunities with smaller market capitalisations.
The UK consumer
In particular we believe this trend has further to run in the UK.
Last year we were pleased to see the consensus’ estimate for growth in 2017 revised up. Yet what drives markets in the short term is not so much the level of growth as the level of growth relative to expectations. As a result, we now see more risk of a disappointment than a pleasant surprise. This leads us towards the internationally-oriented FTSE 100 over mid- and small-cap indices which derive far more of their revenues within the UK.
In particular, we see a threat to household consumption. This is crucial, as it accounts for about 65% of the economy and has been the only component to make a consistently positive contribution to growth over the last three years. Our analysis suggests that real (inflation-adjusted) pay growth is unlikely to return to anything much above zero for the next six months or so, and rising prices will likely erode consumer confidence.
Much of the consumers’ buoyancy over the last two years has come from a willingness to draw on savings and borrow in order to maintain spending. Consumer credit (not including mortgages) has risen by 15% over the last two years. This month, the Bank of England’s Financial Policy Committee expressed alarm at the pace of borrowing, to the extent that it is bringing forward a stress-test scheduled later in the year to July. The June report made clear that the committee are giving serious consideration to regulatory intervention aimed at curtailing retail banks’ ability to extend new loans. This could exacerbate the consumer retrenchment and increase the risk of UK growth disappointing expectations.
Brexit means more Brexit
It’s taken twelve months, but Brexit negotiations got underway in June. While our analysis suggested that the economy and markets would weather the hung parliament, the negotiations are likely to provoke some flightiness.
The government appears to have jettisoned its previous insistence that talks on trade should accompany the first phase of talks, which will focus on rights of EU citizens residing in the UK, the size of the divorce bill and the border between Northern and the Republic of Ireland. Is this the first clear sign of a weakened hand? Regardless, if the economic implications are predominantly about a ‘hard’ of ‘soft’ withdrawal from the single market, we may be waiting some time for any hint of clarity. There is no set timetable for the beginning of phase two.
It is tempting to interpret the election result as a rejection of a ‘hard’ Brexit, but we have not found compelling evidence that it would be in the Conservatives’ own interest to soften their approach. True, of the 86 constituencies in which the Conservatives lost ground, 80 voted remain. But they only held 40 of them to begin with, and managed to hold on to 27. Of the 26 seats Labour won from the Conservatives, only 11 voted “remain”. Meanwhile the Conservatives increased their vote share in far more “leave” constituencies – with a clear relationship between the strength of the “leave” vote and the size of the Conservative gain. They also increased their vote share in 147 “remain” constituencies.
How about austerity? Can we deduce a political incentive to change course here? Again, we find little evidence that the Conservatives lost more ground in seats more adversely affected by cuts in the name of austerity. Importantly, we find no correlation between the impact of austerity and the net change in either the Conservative or Labour vote share. We test for a relationship across various samples (eg. seats with a Conservative incumbent, seats in which Conservatives lost ground, seats in which Labour gained ground, etc.) and do not find one. Defeats of Conservative incumbents were split evenly between constituencies with above and below average effects of austerity.
With some statistical tools, we find evidence that wealthy “remain” constituencies were most likely to move away from voting Conservative. Of the 86 seats in which the Conservatives lost ground, 72 were in constituencies with above average wages. To win these voters back, the government will need to assess whether they voted altruistically or selfishly – a rather difficult task. Certainly, the evidence isn’t stark enough to expect a significant change of tack, and Philip Hammond’s Mansion House speech in June offered little to the contrary. Without easing back on austerity, we think it is unlikely that GDP growth will beat consensus expectations for the next 12 months.
China and its onshore market
We have long expounded China’s importance to investors. The FTSE 100 already has significant exposure to China, which accounts for nearly £1 in every £9 of revenues earned by companies in the index. Yet we don’t believe headline-grabbing news that 222 Chinese ‘A-shares’ (equities traded on mainland exchanges rather than in Hong Kong or other international markets) are to be included in MSCI’s flagship Emerging Market equity index next year is especially significant.
Chinese shares traded outside of the mainland already account for 28% of the MSCI Emerging Market index, against which the 0.7% weighting that will be given to A-shares seems rather paltry. That 0.7% weighting will generate approximately $19bn of purchases from funds which track the index, but again that’s rather small fry compared to the combined $7.7 trillion market cap of those 222 companies. We doubt there is the political will to loosen capital controls to the extent necessary for a larger MSCI allocation.
As we set out in our December 2015 report on the long-term outlook for Chinese growth, prospects are constrained by high corporate indebtedness and low productivity after a decade of poor investment decisions. Using our growth accounting framework, we estimate annual GDP growth will average between 3.5-5.5% over the next 10 to 15 years, dependant on the progress of reform. That’s still higher than most of the world, but not the 9% of the last ten years.
In the report we also argued against investing in the giant, mostly state-owned enterprises that dominate banking and the old, smoke-stack sectors. Over two-thirds of the 222 companies to be included in the MSCI index fall into this category. They are not exposed to the new drivers of China’s economy (consumer services and higher value-added manufacturing) and their share prices tend to be dominated more by (sometimes fickle) government policy than investment fundamentals. We take corporate governance very seriously at Rathbones and while governance in the private-sector is perhaps much better than many might think, many state-owned companies put State interests ahead of shareholders’.
We expect the economy to perform well heading into the quinquennial National Congress in the autumn. However, we anticipate the meeting will mark a change of policy that could (intentionally) slow growth thereafter. As ever, we will endeavour to keep you up to date.