- The US economy continues to remain healthy and this should continue for the next 6-12 months.
- Economists are ratcheting up their forecasts of US GDP Growth and US Corporate earnings.
- The FED is responding to US Macroeconomic strength with a steady program of quarterly rate hikes. The FED has not taken away the punch bowl yet, but with the US labour market pushing to full employment, and core inflation at 2%, there is strong impetus for the FED to gradually move interest rates into restrictive territory.
- The Australian economies growth has been impressive so far in 2018 but is likely to have peaked. The headwind of falling house prices continues to increase and uncertainty around the strength of the Australian consumer remains given high private debt levels which make Australia vulnerable to a global rising cost of capital.
- In Asia, Chinese growth seems to have stabilised and stimulus may even provide a small boost to activity in the region in the latter part of 2018. We expect a robust performance from the Japanese economy into 2019.
- We continue to watch the US 10-year treasury yield which has spiked from 2.0% a year ago, to 3.0% today.
- Our medium-term view on interest rates is there is now a rising risk of inflation accelerating to a point where Central Banks will need to tighten more aggressively than anticipated by markets. This could put pressure on asset valuations which have been priced assuming a low inflation, low interest rate regime is likely to prevail indefinitely.
- Our overall view on valuations has not changed materially. Asset prices generally look expensive with the US market being one of the more expensive markets and Australia, only slightly above fair value.
The Global Economy
The global economic expansion appears to be continuing at a reasonable pace. We still see global growth at something like long-run average, or slightly above at present. But things have become more complicated after the heady talk of synchronised growth at the beginning of the year.
We still believe that there is a risk of the US economy overheating in the next few years. The economy is fully employed, growth in labour costs is slowly rising, and anecdotes of tightness on the supply side have become more common – from difficulties of getting labour, to shortages of capacity in transport services. Growth in the first half of 2018 was above potential. Fiscal policy is stimulatory and monetary policy, while adjusting, could not be described as constrictive yet. Trade policy will not likely have a major effect on the US economy in the near term; in any event, trade policy tools are being deployed mainly in pursuit of US strategic interests, so any adverse economic effects are likely to be regarded by the Administration as second order. But what economic effects there are will work in the direction of tightening the supply side and raising prices. That’s the point of protectionism after all.
So, while a rapid surge in inflation does not appear to be imminent, a slow-burn build-up appears more likely than not, unless one has very strong faith in ongoing effects of price level deflation resulting from technology, globalisation and disruption etc… Bear in mind, too, that the Administration’s overt intention is to restrain or even reverse at least some of those forces. Mr. Trumps administration seems consciously to be seeking economic disengagement with China.
It is still the case that long-term interest rates in the US seem sceptical to the economy’s strength. 10-year yields are below the current and likely near-term rate of nominal GDP growth, even as the short end continues to shift higher. As many have noted, if the Fed stays on its present course and nothing else happens, the yield curve will invert within a year. While an inverse yield curve has not been an infallible forecaster of recessions in the past, its record is pretty good.
We are approaching a very interesting and critical time in US financial markets. Is the bond market signalling something about the growth and inflation outlook that the Fed isn’t seeing? Or is it the bond market that is missing something – perhaps the extent of overheating that could occur?
One new element is the President’s jawboning about interest rates. If, as appears, President Trump’s notion of Making America Great Again involves allowing the economy to run on full steam, it will be unwelcome if someone ‘takes away the punch bowl’. We believe the Fed will ignore this verbal intervention, as they should. Conditions haven’t yet tightened enough to allow any resistance to further tightening to gather any political strength beyond the President’s tweetstorm. The Fed should remain in control of monetary policy.
The Fed however, does not control US exchange rate policy. That is the preserve of the Administration – often implemented via commentary by the Secretary of the Treasury. The current policy settings with fiscal easing, monetary tightening, full employment, and with the US leading the international growth stakes quite comfortably – would, appear to be a set of conditions highly conducive to US dollar strength. A rising US dollar does act to water-down the punch at the party.
We do think there is a reasonable chance that the Administration, unable to deflect the Fed from its course, will choose to exert its discretion in the exchange rate arena. Outright intervention seems unlikely, but periodical jawboning of the US dollar would be a relatively easy tactic to employ. Were that to become a more regular occurrence, the term ‘currency wars’ may come very much back in to vogue, and key bilateral rates like the EUR and especially the RMB could get more volatile.
Meanwhile the trade war continues to escalate, with some European targets now in the Administration’s sights. Turkey, which is among the top ten sources of imported steel for the US, was hit with a tariff announcement while already reeling from a currency collapse. Turkey has for a while had many of the ingredients for trouble in a world in which US interest rates and the US dollar are trending higher: a substantial current account deficit, US dollar borrowings, domestic budget deficit, a nasty political regime.
Thoughts of investors naturally turn to potential contagion, and to analyses of which other emerging markets have similar characteristics. It is always a challenging experience for emerging markets in this stage of the credit cycle.
What is different about this administration, is it has become comfortable acting in a way that seemed to add to instability in markets. This contrasts with previous American behaviour which sought to calm things at times of crisis. It is almost twenty years since ‘the committee to save the world’ – Rubin, Summers and Greenspan – appeared on the front cover of Time magazine. Such US efforts had perhaps mixed success over the years, and the US was not above using crises and their influence at international organisations to push political or strategic interests. But at least we knew that, in the end, the US would try to contain financial turmoil, because it saw such action as in its own interests, recognising the interconnections in the system.
It is hard to be confident that the current Administration sees those connections in the same way. At least not yet; should turmoil in emerging markets or Europe feedback to American asset values, that may change. At present, Trump playing with matches seems to be fun, and perhaps wrong-footing the leadership of other nations is a tactic that the administration feels is working.
In China, GDP growth is shown as steady at a year-ended pace of about 6 ¾ per cent. Under the surface, of course, there is a lot going on. While bottom line growth has not changed much, some components have shown signs of more appreciable slowing. The backdrop is the intent of the policy makers to de-lever the economy, but without causing a crash. This is a hard balance to strike in any country; few have managed it.
At this stage, the evidence suggests some success in bringing the credit boom to earth reasonably gently. But it is early days and certainly way too early to draw any strong conclusions about how successful the deleveraging strategy will be.
In any event, Chinese economic policymakers don’t seem to be inclined to take too many chances. Policy has lately been in easing mode again. Whether this is due to discomfort about those impacts of the deleveraging strategy that are apparent, or whether it is due to concerns about the likely impact of US trade policy on the Chinese economy, is an interesting question.
For the moment though, it seems that China continues to grow, and policy makers are once again erring on the side of growth rather than restraint. Interest rates have fallen, reserve ratios have been reduced, and the yuan has depreciated.
So far, the impacts of the trade war with the US have been negligible. If China begins to experience export weakness, it is likely they will respond by attempting to boost domestic demand via targeted stimulus. The fact remains that US business just won’t be able to find the low wage workers or production capacity to replace Chinese imports. This will add upward pressure on US inflation and interest rates. So eventually Trumps tariffs will start to hurt US businesses and voters. At this time, we still believe Trump will follow the precedents of his conflicts with North Korea, the EU and Mexico. He will likely “make a deal” that fails to achieve his stated objectives but allows him to claim a “Win”.
Growth in the euro area, which was accelerating in late 2017 has moderated – back to Europe’s more conventional pace of 1- 2 per cent. This is, no doubt, a bit disappointing to some European policy makers, especially those hoping for an earlier return to more normal policy settings.
It makes the return of inflation to the ECB’s ‘close-to-but-below-2-per- cent’ objective on a sustainable basis seem like it is still a little way off yet. CPI inflation is 2-ish at present due to energy price lifts, but core rates are still about 1 per cent. So, the ‘below 2’ part of the ECB’s mandate seems more in operation than the ‘close to 2’ part. That hasn’t stopped ECB President Draghi proceeding with announcing a taper of the ECB’s asset purchases, but it seems an actual lift in rates is some time away yet.
Still, the step down in growth doesn’t seem to be developing into anything more sinister. It is more a case of back to the ‘same old’ growth performance we normally expect in Europe, where demographics and structural rigidities combine to keep potential growth low and where ongoing financial difficulties – e.g. in Italy – remain a steady headwind.
Locally, it appears the economy has been performing better than one would think given the political backdrop. The NAB business survey readings have been at levels that are about as good as it gets. Some moderation from those levels is still consistent with quite reasonable growth.
Employment growth has been slower this year than last, but 2017 was exceptional: you don’t get 3 plus per cent annual growth in employment very often. The mining investment downturn has ended, and things are looking up in some of the mining areas. Some state governments are running infrastructure programs of substantial size. The extent of improvement in the Federal Government’s finances has also been quite noteworthy and has changed the complexion of the government’s economic narrative. We are not back to the ‘tax cuts and a surplus every year’ world of the mid 2000s, but things seem a good deal easier on the fiscal side than they were a couple of years ago.
It seems that the main thing people have to complain about is slow wages growth. Even there, the minimum wage is still rising at 3 per cent, which is a reasonable lift in real terms; it is people in the middle of the income distribution that have seen the bigger squeeze over recent years. Part of the reason for slow wages growth, of course, is slow price growth, and vice versa. Inflation is a bit low compared with the RBA’s target, but only slightly.
House prices have been declining a bit but that was always on the cards after such a strong run up, and it is hardly unprecedented. While the tightening of lending standards has been credited with causing this, probably at least as big a factor is simply that ‘affordability’, or lack of it, ultimately constrains prices unless interest rates keep falling and/or credit standards become ever more relaxed. Neither of those has happened and are likely to tighten further in the years ahead.
In addition, as the Reserve Bank started to say more than two years ago, quite a bit of supply is coming on stream. Eventually supply responds to demand, even though that takes quite a while, and the market becomes more balanced. That is actually the system working.
Despite all the talk about financial stress, households’ arrears on loans remain low. Admittedly that is with interest rates very low, with competition for the marginal owner-occupier borrower very much alive. Still, most observers seem to be thinking that rises in official rates will be a while coming yet and will probably be very gradual when they do come – just as has been the case in most other places around the world. In our opinion, while we expect house prices to moderate further, a “crash” as hypothesised by a recent 60 minutes story looks very unlikely in the next 12-18 months unless there is a deterioration in the global economy.
So the international expansion continues, but with plenty of worries for market participants to fret about. And while the near- term future seems still to be one of growth, it also seems to be shaping up as one where a slower pace of globalisation, and perhaps de-globalising in some cases.
If so, this may in time pose some big questions for highly trade-dependent economies, especially in Asia. To add to that, the emerging world may be less clear, and less confident, about what sort of safety net, if any, remains in place should they get into trouble. Perhaps all of us are less certain about the rules of international commerce now. We believe it is this uncertainty that is acting to temper animal spirits and extend the current economic expansion. Short of Trump escalating the trade/ economic conflict with China, the US should continue to grow at pace for another 12-18 months before a slowdown in late 2019-2020.
Consequences for Asset Allocation and Portfolio Construction
So how are we thinking about investing at the moment? Generally bullish over the next 6-9 months, but nervous. This long into an economic expansion, generally investors are complacent and valuations for major asset classes appear stretched. The table below from Perpetual’s multi asset team shows that their current 5 year forecast return for most asset classes is well below long term return expectations. While long term forecasts are very useful in telling us where valuations are today, even if they prove to be correct they generally aren’t useful predictors of shorter-term returns.
While valuations are suggesting we should be thinking defensive, there are risks in doing too much too soon. The US S&P500 has been the best performing regional market so far this year. With fiscal stimulus set to continue into 2019 we expect the earnings momentum to continue to drive the US market higher even as the cyclically adjusted Shiller P/E touched 33 times its 10-year average, which is the highest level ever outside of 1929 and the late 1990’s. Currently in the US, Q3/18 consensus EPS looks likely to be up around 25%, economic activity remains robust and business sentiment remains high. Over the next 12 months these quarter on quarter comparisons will become more difficult, but growth should remain strong for at least another 6 months.
Emerging Markets are the one place valuations looks attractive as they have been sold off due to $USD strength and trade concerns. While they appear oversold, we believe the risks of an escalated trade war and a stronger $USD on the back of further US rate rises auger caution for now. They may well get cheaper before they find a bottom. Certainly, we are watching this space, but feel it is too early to go into EM just yet.
In credit markets there is a historically narrow gap between yields on below-investment-grade corporate debt and “risk-free” U.S. Treasures. In other words, investors are demanding less of a premium to hold riskier debt. This indicates that credit markets still feel a recession is some time off. The negative for us as investors though is we are not being paid very much to take the additional risk to lend to corporates. Before each of the last 3 US recessions credit spreads have widened and we expect the same to occur before the next downturn. For the time being we are going to have to accept relatively low returns from our fixed income allocation in the portfolio.
The diversifiers or alternative strategies in a portfolio (Global Macro, CTA and Market Neutral) have underperformed against equities and struggled to outperform cash over the last 12-18 months as the equity bull market has endured. The primary objective of these strategies is to make money in a bear market and hopefully outperform cash the rest of the time. This cycle, albeit disappointing for macro, market neutral and CTAs to date, hasn’t been significantly different than the previous ones. If a trade war escalates and emerging markets continue to deteriorate, the increase in volatility could create opportunities for them and we believe clients should maintain the exposure to alternatives as portfolio insurance for when the inevitable downturn eventually arrives.
So, in summary, we have a text book late cycle environment. Equities while looking expensive have outperformed and are likely to do so until the economy deteriorates. The diversifiers have underperformed, and the temptation is there to give up on them, but usually that is the time when they become most useful. We do not think this is the time to have extreme conviction in any asset class and diversification makes sense until valuations become more compelling.
- Perpetual Asset Management
- Ellerston Capital, Thought Piece (Glenn Stevens August 2018)
- Robeco Institutional Asset Management, 5 Year Expected Returns (September 2018)