Capital markets have not been as quiet or boring as one might reasonably expect in the middle of summer. European stock markets in particular have continued to grapple with the perspective of their central bank threatening to take away the (easy money) punch bowl, just when their regional economy is shyly starting to ‘party’ a little. It appears that the prospect of monetary policy change will keep markets in motion for a while. Meanwhile in the US, an established pattern of bluster and fury from President Trump is barely disguising the fact that policy initiatives are at a standstill. In short, we have found our expectations of vulnerable equity markets confirmed, even if we continue to see this more of an issue for the much higher trading US equity market than Europe’s far lower valued stocks.
European Central Bank’s (ECB) president Mario Draghi had sought to reassure markets that the Eurozone’s central bank would not tolerate significantly tighter financial conditions. Instead, markets took it as confirmation that the ECB’s direction of travel had changed. This, together with increasingly disappointing political prospects in the US for any Trump driven fiscal stimulus or deregulation relief, led to a rally in the value of the euro, while the US dollar sold off.
Such euro strength in itself should lower the need for the ECB to reduce monetary liquidity in a hurry, because it lowers prices for imported goods and undermines export competitiveness, which combined reduce any feeble inflationary pressures further and prevent overheating of economic activity. This is precisely what we observed when the dollar rallied three years ago, on the back of the US Federal Reserve’s own quantitative easing taper program.
Just as was the case with the previous dollar strength, we do not foresee the strength of the euro to become a significant headwind for Europe’s recent economic revival. An overly strong euro would also reduce the value of European companies’ overseas revenue streams, which would explain the sudden fall in share prices, when actually normalisation in central bank policy should be seen as a positive sign of a strengthening economic outlook. Instead, we observe earnings announcements, which show continued faster growth of corporate earnings than in the US, where earnings are still expected to be running at a very respectable growth rate of 10% year on year.
1. The IMF offers its top-down view of the economic landscape
The latest set of economic data and forecasts from the International Monetary Fund (IMF) offer plenty of food for thought. Given the constant concerns by so many that the next global recession may be just around the corner, global growth coming in above 3% for this year and next year is certainly reassuring. But while stronger activity in India, Canada, and in both developed and emerging markets has helped the global picture, it is interesting to note the IMF’s revised estimates based on changes in policy assumptions for the world’s two largest economies, the US and China.
A key concern for the Chinese economy springs from its growing level of debt. However, this is not dissimilar to the situation many other developed economies are facing. In a number of countries, loose monetary policy has led to an intended expansion of credit. As and when growth recedes, and central bank policy tightens, it becomes harder for households and businesses to repay their debt. This tends to lead to amplified falls in demand compared to lower leveraged economies, which then impacts the severity of the next economic cycle.
As for the US, it seems that President Trump’s much vaunted fiscal and de-regulatory stimulus has failed to gain any traction. As a consequence, the IMF and others are sceptical about any enhanced short-term prospects for the country. The major factor behind its revised growth numbers, especially for 2018, is the assumption that fiscal policy will be less expansionary than previously assumed, given the uncertainty about the timing and nature of US fiscal policy changes. As we know, market expectations of fiscal stimulus have also receded.For the UK, growths forecast has been revised down for 2017 as a result of weaker-than-expected activity in the first quarter. With long-term inflation potentially easing, consumer spending reducing and exports taking an unexpected back-step, the UK is precariously balanced. Indeed, some economists are more pessimistic, suggesting the UK could experience a technical recession over the next 12-18 months.
Clearly, beyond the US, other regions and countries may also be in different (monetary and policy) cycles, and the recovery in many regions still appears fragile and susceptible to headwinds and risks. We believe macroeconomic policy should continue to be broadly accommodative until there is a sustained uplift in core inflation, and economic growth is effectively self-sufficient (and no longer reliant on central bank and/or government policy).
2. Q2 earnings reassuring, but concentrated among the tech ‘Super Stars’
When it comes to the earnings-reporting season, the first quarter (Q1) of 2017 was always likely to be a tough act to follow. We witnessed double-digit year-on-year (yoy) earnings growth across the world, the strongest quarter since Q3 2011. However, with over 25% of the companies listed on the US S&P500 Index having reported their Q2 earnings, this season is turning out better than expected, particularly among technology firms.
So far, 79% of the companies that have reported have beaten earnings expectations, comfortably ahead of the 70% one-year average beat rate. 73% of firms posted better than forecast sales, again notably better than the 56% one-year average. If this rate of sales growth holds, it would represent the highest surprise deviation versus analysts’ predictions since FactSet began tracking the data in Q3 2008 (the previous record is 72% in Q2 2011).
However, there is another aspect arising from these earnings results, which is worth some attention. That is the increasing size and importance of just a handful of large technology firms. Amazon, Microsoft, Apple, Google (Alphabet) and Facebook have become an exclusive club of firms with larger than $500 billion market capitalisation. These are the market’s “Super Stars”, known for their ability to generate enormous shareholder value and influence most of our lives.
This is not without historical precedent during periods of substantial technology advancements. A handful of rail and steel companies prospered during the industrial revolution, as well as car manufacturers, machine builders, oil and telecoms companies during the 20th century. But when there are fewer competitors in any market, there is a high probability that the efficiency of the respective market declines, as the surviving few are able to make life easier for themselves and building increasingly high barriers to entry. What’s more, their purchasing power can dictate conditions in their favour for larger and larger parts of the economy.
Following on from this, one could argue that in benefitting from technological advancements through the ‘internet of things’ the new super star companies have contributed to the slow wage growth and lack of productivity-improving investments in the more traditional areas of the global economy. Let us hope then that, as we have experienced in previous generations, mankind is not only capable of creating astonishing technological advancement, but also can recognise – and respond to – the human consequences that such revolutions engender.
3. UK consumer credit growth: danger or opportunity?
As noted, the UK economy continues to throw out mixed signals. Towards the end of the month, Alex Brazier, who is a member of the Bank of England’s Monetary Policy Committee (MPC) rang alarm bells with a speech warning the easy credit conditions offered by UK banks risks endangering “everyone else in the economy”. He spoke of lenders “dicing with the spiral of complacency,” where “lending standards can go from responsible to reckless very quickly”.
Meanwhile, the latest surveys from the Confederation of British Industry (CBI) found that, in reversal to the first quarter of the year, consumer demand is looking much more healthy, after retail sales shot higher. According to the CBI, recent warm weather has led consumers to defy expectations, with clothing sales leading the charge.
Strangely enough, both Brazier’s warning and the boost in retail sales come as credit growth has actually started to slow. In early July, the Bank themselves reported that the availability of consumer credit had tightened in the second quarter of the year, as retail banks cut back on the supply of unsecured lending. Even more recently it was reported that mortgage approvals fell slightly from May to June, while annual credit card borrowing stayed flat at 5.5%. Overall, consumer credit growth was 1.9% year-on-year last month, down from 2.1% the month before. Comments from such high-ranking officials understandably rattle the public, but we should remember that such warnings can often be amped up to scare the intended targets – in this case the banks.
Perhaps consumer and employee confidence is right, and the Eurozone growth will find its way to the UK over the rest of the year. Unfortunately though, if this does not happen, then we can most probably not count on the trusty UK consumer to bail out the domestic economy once again. All in all, much depends on whether wage growth will be as bad as expected in the months and years to come. With saving rates running at their lowest, wages not growing in real terms and credit balances hitting ceilings as well, there just isn’t any further funding headroom.
4. Is India building a wall with China?
India continues to undergo a transformation process under the leadership of Narendra Modi, and there is strong evidence that the ‘Modi effect’ is delivering for a demographic that is extremely hungry for change and new opportunities. This view was shared by the International Monetary Fund (IMF), whose growth projections show the country’s GDP reaching 7.2% in 2018 and 7.7% in 2019, nearly double the average global growth rate projected and even around 1% ahead of neighbouring China.
A young demographic and workforce – approaching the size of the Chinese but cheaper and growing trade – mean the country is a mirror of a younger China. This view is clearly shared by the Chinese, and is a potential worry for the Chinese at the same time. This ‘younger China’ may be seen as an unwelcome competitor for China, taking trade and future growth from the country.
Those who follow current affairs will be aware of the recent rise in tensions between China and India, with the latest ‘high-stakes, high-altitude border row’ taking place on the Himalayan Plateau Bhutan. This is a strategically key territory for India, known as the “chickens neck”, connecting India’s tea-producing north eastern provinces to the rest of the country. For China, the territory provides military coverage for the region but also encroaches on this key trade route, a threat not taken lightly by India.
In the long run, the importance of good relations between China and India is required from a trade perspective. China has a growing middle class with greater propensity to consume and India can reap the rewards. In the short term, there is no doubt about the potential for short-term uncertainty and limitations to trade with China reinforced with a military standoff. For many countries in Asia, Chinese military might has overridden any ability to stop territorial moves. But for India, the locations are too close for comfort, and it may be the first neighbour to stand up to China. Even if no military events occur, the ‘Indian Wall’ is likely to remain in place with high geopolitical tensions, and pride, at stake.
5. Japan’s comeback story looks to be running out of steam
Earlier this year it looked like Japan was finally escaping the clutches of nearly three decades of deflation and tepid growth. In particular, Japan’s tightening labour market – and rising real wages in its wake – gave rise to expectations that domestic consumer demand would reawaken.
In many respects, things are still going rather well in Japan’s economy. Exports rose for a seventh consecutive month in June, but the rate of growth is slowing. Conditions are still generally expansionary, but prospects don’t look quite what they did two months ago. Political fears have also returned. Prime Minister Shinzo Abe’s ruling party lost an important Tokyo assembly election this month, scoring a record-low 23 seats. Abe’s approval rating has fallen to 34%, meaning his leadership could be challenged next year.
Most recently the Bank of Japan opted to keep its monetary policy unchanged. But more significantly, it cut its inflation forecasts for the next three fiscal years, with its 2% inflation target pushed back once again. The bank now expects to see only a 1.1% rise in the CPI inflation measure for the fiscal year, compared with a 1.4% forecast back in April. Likewise, inflation forecasts for 2018 and 2019 have been cut, from 1.7% to 1.5% and from 1.9% to 1.8% respectively.
But Japan’s most pressing issue is the continued lack of consumer demand, reflected in slowing import growth and, more importantly, chronically low inflation. The Japanese have long had a tendency to save rather than spend, which takes productive capital out of the economy and presents a real barrier to growth. Unless this aspect is addressed, it’s unlikely that we’ll see the economy firing on all cylinders.
Whatever the case, we are slightly less optimistic on Japan than some months ago. Falling optimism isn’t the same thing as pessimism, however, and the economy is still growing at a much better rate than over most of the past 25 years. As ever, the issue remains deflation. While the Bank’s monetary policy alone is unlikely to stimulate demand enough to address this, we hope at least one of the three arrows of ‘Abenomics’ will hit the bull’s-eye.
6. Thoughts on political vacillation and the uncertain direction of travel
This environment of plenty of distractions but limited fundamental news lets us turn our focus to the longer-term outlook. Unsurprisingly there is plenty of debate about where this very stretched out economic cycle is heading, and how long it will last. However, amid the noise a few threads are becoming apparent.
One school of thought goes as follows: economic progress is still below average after the almost ten year hangover of the global financial crisis. But given the low levels of inflation and accommodative financial conditions, the economy is actually running under ‘goldilocks’ (not too hot, not too cold) conditions – and with little risk of change in either direction. As such, owners of capital assets and/or with professional skills and education will continue to do well. But there’s a fly in the ointment. The status quo comes with high levels of debt, plus the discontentment of the ‘have-nots’ without capital assets or professional careers. Such debt can become a burden if yields ever return to historic levels, but inflation stays low - and there is a risk that the young, the asset-poor old and the general workforce abandon the status quo and exercise their democratic rights to change the rules of the game.
The other school of thought proclaims that there are more fundamental forces at play, which have led to an unsustainable misbalance amongst western societies. Globalisation and the technology revolution have diminished the negotiating position of labour, leading to a sharp drop in living standard improvements. This, together with the baby boomer generation’s determination to hold on to the value of their aggregated lifetime assets, is preventing gradual change and improvements for the young and labour, as may be achieved through re-distributive policies and restrictions on purchasing power abuses of the new (technology-led) monopolies.
The ultimate outcome of this scenario would be the gradual demise of the global economic leadership of the G7 nations, as political disarray leads to even greater fractures in society and worsening recessionary periods. New economic leaders would then emerge from within the developing world, which is not yet saddled with similar issues.
These are somewhat complex concepts to wrap one’s head around, but both theories go some way to explaining why there is so much talk about the unchartered territory ahead, and why it is proving so difficult at present for politicians to take decisive action.