Corospondent - January 2018
International Outlook - January 2018
The MSCI All Country World Index posted a positive total return of 24% in US dollars during 2017. Global equity markets have continued to benefit from a combination of broad-based economic growth, low inflation, tax changes in the US and supportive central bank policies. Over the course of the year, emerging market equities have outpaced developed market equities by more than 13%, with an impressive US dollar return of 37%.
Global economic growth continues to impress, with JP Morgan estimating that global real GDP has expanded at a solid 3.7% annual rate during the second half of the year. That said, there is some evidence that growth by that measure has cooled to an estimated 3.0% pace in the fourth quarter. This is due to two near-term drags – the 30% rise in energy prices in the second half of the year and the impact of China’s credit tightening on credit-intensive sectors like housing and infrastructure. But the global expansion is now so broad based that there are likely to be positive feedback effects, supporting financial conditions as well as business and consumer sentiment. Indeed, JP Morgan’s measure of global consumer confidence has reached its highest level in over a decade, suggesting that any impact on purchasing power from higher oil prices is likely to be modest.
Following the 0.25% rate hike by the Federal Reserve (Fed) during December, some observers are concerned that the associated flattening of the US yield curve is pointing to a significant slowdown ahead for its economy. But arguing against that view is the growing likelihood of US fiscal stimulus associated with the recently approved tax cut package that became the Republican Party’s number one objective.
Additionally, the fact that overall financial conditions remain buoyant, as reflected in high stock prices, tight credit spreads and the very high level of Bloomberg’s Financial Conditions Indexes argue against an imminent slowdown. Although Fed funds futures are pricing in two further rate hikes in 2018, projections by Fed officials are pointing to the need for twice that amount of tightening. The Fed’s view will have been reinforced by the passage of the tax cut package, which is widely expected to add more than $1 trillion to US debt over the next decade.
In contrast to the Fed, interest rate normalisation by the European Central Bank (ECB) and the Bank of Japan is expected to proceed much more slowly, with core inflation in the euro area having stalled at 0.9% in November, while core inflation in Japan remains zero on a year-on-year basis. That said, the euro area economy continues to power ahead, with economic sentiment in December at a 17-year high. Growth has been strong of late and appears to be broadening, with deflationary risks having all but disappeared. Politics suggest that fiscal spending could increase in some countries, including Germany. Inflation could tick higher and force the ECB to start talking about rate rises. ECB president Mario Draghi could of course find some way to extend quantitative easing well past September 2018 in a difficult balancing act that increases the risk of a policy error. Japan’s economy also remains on a solid footing, as reflected in a very strong Purchasing Managers’ Index reading for November and a government survey showing stronger capital spending growth in the most recent quarter.
The focus on China is less on interest rate policy, which remains neutral for now, and more on credit policy. New regulatory efforts were announced to reign in excess credit growth and reduce the implicit guarantees embedded in continuing risky, off-balance-sheet lending. This has created uncertainty in China’s financial markets, triggering rising bond yields and volatility in domestic equities.
With the government aiming for a soft landing, the most likely scenario for 2018 seems to be further deceleration in credit-intensive sectors like housing and infrastructure, offset by a stronger contribution from export sectors that benefit from improved global growth and the decline of nearly 10% in the trade-weighted currency since early 2016.
THE RISKS OF COMPLACENCY
Looking ahead to 2018, conditions for global equity markets continue to look reasonably good in the context of a broad-based global expansion and generally accommodative monetary policy. But valuations are a concern, particularly in the US, where the Shiller cyclically adjusted price earnings ratio is at the 95th percentile of its historic range since 1926.
Valuations outside of the US are generally less elevated, and on conventional metrics, the MSCI Europe, Australasia and Far East, and the MSCI Emerging Markets indices trade at 14.9 and 12.3 times estimated earnings respectively, compared to the MSCI USA Index at 18.7 times. Against the backdrop of still-low global bond yields, this suggests that global equities remain attractive relative to fixed income, albeit somewhat less so than was the case over the past few years.
Global markets saw some geopolitical-related wobbles, specifically around Brexit and US politics, but even the German, Dutch and French elections caused only very minor disturbances. But overall, the market trajectory over the last 12 months, if not 23 months, has been almost unique in history – leading to an increasing number of commentators making a fundamental case that equity and credit markets are at bubble valuations. They point to charts supporting their thesis that the market is technically overbought and sentiment is at extremely positive levels, which could potentially trigger a correction. Meanwhile, the momentum in markets remains upwards, with bearish sentiments having to be tempered at the moment. Despite warnings, the majority of investors simply appear to have adopted a momentum and yield strategy; that is, they will remain invested in risk assets until the market turns.
Given that we are at the start of a new calendar year, some perspective is called for. As outlined, the market environment for equity and credit markets has been quite extraordinary in 2017. It is worth noting that, historically, US equities perform best in the second half of an American presidential term. However, this pattern has been distorted over the past decade by the bounce-back from the deep recession of 2008 into 2009, followed by the flood of central bank liquidity injections – and related suppression of yields which in turn fed a global rotation toward momentum-driven equities, dividend-yielding equities and corporate debt.
That said, it must be pointed out that the suppression of yields by central banks over the last five years is really only a tailwind to a decline in yields that has been in progress since the early 1980s. While there is little doubt that, as quantitative easing programmes around the world are slowly shut down, yields will rise, the strategic outlook will also depend on background forces that have contributed to lower yields for a long time. This global excess of mobile liquidity should continue to buoy equities into 2018. Responding to a modest but synchronised upturn in the global economy, pragmatic investors continue to direct mobile capital toward equity risk. Investors reason (or rationalise) that with no viable alternatives, this will remain the most prudent allocation of client assets. Worryingly, complacency hides risks posed by the eventual end of central bank bond buying and overdependence on index funds, especially those that are leveraged. The key point is that asset price appreciation in equities, credit, sovereign bonds and other asset classes has been strong throughout the careers of the majority of people currently employed in finance – but logic suggests that this dynamic seems likely to come to an end.
STRUCTURAL PROBLEMS ALLEVIATED BUT NOT SOLVED
Risks are mounting. These include the unravelling of western geopolitical alliances, the drift toward military miscalculation in Northeast Asia, and slow but relentless economic transformations within countries and economic regions. Although many individual investors worry that equities are overvalued, they continue to rotate their capital (and hope) towards, for example, momentum-driven cryptocurrencies or cash-burning shares such as Tesla. As highlighted, in the short term, reasonable growth, excess liquidity and negative real interest rates will continue to support the rotation toward economic and equity risk. But later this year and into 2019, events will most likely trigger an abrupt repricing of risk. The knock-on effect of this will, if current trends are any guide, further inflame populist antipathy toward ruling elites and the status quo around the world.
The causes of the political uncertainty in western industrialised nations are not hard to find. A sharp decline in economic prospects, stagnating real wages, job insecurity, pension systems under threat and growing inequality have combined to create a sense of discontent. These are largely the result of long-term structural problems. The recent global cyclical upswing will alleviate some of these in the short term, but it will not solve them. And although the global economies are growing and unemployment has fallen, wages remain stubbornly low.
Statistics from the IMF show that while unemployment has fallen to below 6% across advanced economies, annual wage growth has barely moved above 2%. We may be experiencing an upturn but for many, little has changed or improved. Against this backdrop, the impending end to central banks’ expansive monetary policy, or quantitative easing, of the past decade is another source of uncertainty. The tricky part is that normalising monetary policy means undoing 10 years of monetary stimulus. This is something that, in our opinion, investment markets are too complacent about and unprepared for. Central bank balance sheets have never been so large and are in unprecedented territory. Simply put, interest rates are extremely low and global debt is extremely high.
WHAT CAN GO WRONG?
While the current benign inflation environment has dampened investor fears, more forward-thinking commentators recognise that we are in unchartered waters. Today’s low financial market volatilities are deceptive and underestimate the underlying risks and uncertainties – the point is that the long-term effects of quantitative easing are not fully understood and that the impact of reversing this process therefore remains unknown. Uncertainty of this type should be reflected in increased risk and therefore the pricing of risk. This leaves investors with a conundrum: how to explain the discrepancy of high levels of uncertainty coexisting with financial market complacency.
The implicit message at present therefore seems to be that, due to the high levels of uncertainty, risk cannot be accurately priced. Equity markets are very clearly ignoring the uncertainty at present. This will, as is always the case, change at some point. In the mean time, both investors and policymakers will enjoy the upswing while it lasts, knowing that it will not last indefinitely. Investors should therefore prepare for a return of volatility. In a period of uncertainty, portfolio diversification is becoming increasingly vital.
Concerns as to where inflation is headed leaves investors with continued uncertainty as to where interest rates will wind up. But it would be reasonable to conclude that a significant inflation shock would be a major negative force affecting today’s investment portfolios. Despite deflation being the dominant fear since the 2008 financial crisis, it seems likely that a meaningful increase in inflation from here would trigger larger portfolio losses than a depression. While depressions are bad for risk assets and good for quality bonds, inflation is very bad for bonds and mildly bad for stocks.
As things stand now, bonds would do particularly badly given their very low real yields. However, shares could get more severely hit given their extremely high valuations. Although we do not know if an inflation surge is inevitable, it is something that investors should have in the forefront of their minds when they think about what could go wrong for their portfolios.
This does not mean we need to prepare for an abrupt multi-asset sell-off, but it is likely to mean a strategic change in the asset return environment that investors will not be used to. This will also have profound implications for the structure of the finance industry and the question of active versus passive stock selection. An unanticipated low return outlook will challenge the methodology and even the goal of investments, all of which have been predicated on the belief that returns from asset markets are higher than the return demanded to fund the savings needs of society.