Feature Stories | Jan 17 2018
The story below was originally published on 13 December 2017. It has now been re-published to make it accessible to a wider audience.
2017 has been a remarkable year in global markets. Will it all come to an end in 2018? Or 2019? Brokers, economists and research houses offer their views.
– 2017 a remarkable year
– No reason for it to all end in 2018
– There are nevertheless risks, including monetary policy
– Yet investors are cautious, not complacent
By Greg Peel
It is inevitable that economies undergo cycles. Economies will strengthen and asset valuations rise until confidence becomes complacency and both begin to overheat. Rising inflation forces central banks to tighten and a recession is triggered.
Fear ultimately subsides to begrudging acceptance and asset valuations fall too low as a slowing economy begins to bottom out after central bank easing.
Rinse and repeat.
It is this inevitability that leads analysts into assessing at just which point in the cycle an economy may currently be: early, mid or late. Early suggests the beginning of a bull market, mid suggests stay on board and late suggests a recession is coming, time to exit.
With hindsight we can note that the US bull market began in 2009 after the Fed introduced its first round of QE – the equivalent of easing to a negative cash rate – in the wake of the GFC. That bull market is now one of the longest in history.
Europe was even more hard hit by the GFC and thus did not enjoy a simultaneous recovery with the US. Lingering PIIGS issues, the long-running Grexit scare and the constraints of a single currency meant Europe’s GFC extended for a few more years before an economic recovery was evident.
Beijing avoided a GFC in China by throwing historic amounts of fiscal stimulus at the Chinese economy but after reaching a peak, China’s growth rate has been slowing ever since.
Japan was already in a recession thus didn’t notice much difference.
Emerging markets (and by now we can leave China out of this group) were hard hit by the GFC but have since been beneficiaries as China’s economy matures, particularly among China’s near neighbours.
2018 will mark the tenth anniversary of the Fall of Lehman. 2017, all analysts agree, has been a remarkable year. As hackneyed as her name has become, Goldilocks remains the best analogy. Can 2018 bring more of the same? Or is it time to start worrying?
2017 – The year of synchronicity
Of the 198 countries party to the International Monetary Fund, only six are currently suffering economic contraction, Legg Mason notes. Half of those are in the Caribbean, recently ravaged by hurricanes. The rest are in Africa.
Morgan Stanley notes that while US tech stocks received most of the attention in 2017 (and fair enough too, the FANGs and friends are alone responsible for some 25% of Wall Street’s gain), it was actually one of the broadest equity markets on record, globally. There were no meaningful pullbacks, making risk adjusted returns “almost absurdly good”.
ANZ Bank economists note the global recovery so far has been helped by some “serendipity”. Political risks in Europe (at least in terms of EU break-up fears, while there are other risks, more on that later) and Trump have not done much damage to global trade, yet. China has again managed to deal with its issues, to the surprise of many. And consumers have continued to spend despite low income growth.
A combination of solid global growth and low inflation has seen risk assets move substantially higher. But despite the strong gains, the rally has been amongst the most “unloved” in history, as Macquarie notes. A common analogy is “climbing a wall of worry”. Concerns over stretched valuations and the risk of further shocks have kept many investors on the sidelines.
In essence, 2017 was so good it was almost too good, and that’s why the concern. Nothing that good can last forever.
Where are we?
Analysts all agree that after eight years of growth, the US economy is now late in the cycle. However that does not mean “get out now!” Economies cycle in years, not months or weeks.
To that end, we can drop down another level and assess whether we are currently early in the late cycle, in the middle, or late in the late cycle. It is only late in the late cycle that investors need to batten down the hatches.
While consensus also has the global economy under a banner of “late cycle”, realistically the synchronicity story breaks down here. Some developed market central banks have begun to tighten monetary policy (most notably the US) but others remain in easing mode as yet (Europe, Japan).
Morgan Stanley suggests the US and China are late-cycle, the EU and Japan are mid-cycle and emerging market commodity exporters are only early-cycle.
While there is disparity among central banks with regard monetary policy, it is not stark. The Fed’s pace of tightening has been gradual. The ECB is still implementing QE but next year will begin to back off. Japan will enter 2018 without any change to its negative cash rate policy. The reason no one has proceeded to barrel into monetary tightening even eight years after a recession is because inflation remains stubbornly low. “Mystifyingly” low as far as the Fed is concerned.
The clearest sign an economy is about to blow off and tip into recession is too-high inflation, leading to central banks slamming on the economic breaks. The primary driver of too-high inflation is rampant wages growth. Globally, wage growth remains benign.
Canaccord Genuity suggests given some central banks are now tightening, the early stage of the late cycle has passed. But because some aren’t, the late stage of the late cycle is yet to be reached.
Goldman Sachs notes economic cycles and bull markets do not generally “die of old age”. Major pullbacks require triggers. The most severe type of bear market is structural – the consequence of the unwinding of major economic imbalances and, typically, a financial bubble (See: GFC). Cyclical bear markets are the function of the economic cycle and are almost always triggered by the tightening in response to inflation pressure.
Goldman believes the risk of a structural bear market is low given those imbalances existing pre-GFC have been reduced or shifted to central banks. Cyclically, without higher inflation it is unlikely we have the conditions for a recession and, therefore, a bear market.
There is nevertheless one point of concern among market-watchers: the US yield curve is flattening.
The Yield Curve Mistake
A yield curve represents a line drawn between the overnight cash rate, through short term bond yields and on to long term bond yields. A healthy economy would be represented by a positive yield curve – interest rates rising from short to long. Higher long term yields suggest faith in a growing economy.
But when an economy begins to overheat, inflation rises. This forces a central bank into raising the cash rate, while higher inflation priced into the longer term reduces longer term rates. The yield curve flattens, and then turns negative. The rule of thumb is a negative yield curve portends a recession in 6-12 months’ time.
Over the course of 2017, US stock prices have soared while the US yield curve has begun to flatten. Ergo, say some, a recession is coming in the not too distant future.
But to heed to this supposed yield curve truism, and, equally, to find low inflation in a period of synchronised global economic growth “mystifying”, is to linger in the past. Globalisation was not a word when the economics text books were written that still inform today's assumptions.
The US economy is no longer an economy in isolation from the rest of the world. The yield curve argument would hold true were inflation rising, but it’s not. The US yield curve is flattening because US short term rates have begun to rise on Fed tightening but US long term rates are being dragged down by the differential to long term rates in Europe and Japan in particular.
If US long rates were much higher, one can borrow in yen and invest in US bonds for what is a “carry trade” that is profitable as long as exchange rates remain stable. The more investors jump on the carry trade, the faster the differential will close. European and Japanese long bond yields remain very low, hence US yields are low. The Fed is tightening but the Bank of Japan is not, and as yet the ECB is not.
To this end, suggesting a flattening US yield curve is pointing to recession is “erroneous”, as Canaccord puts it. An alternative gauge of US growth – the ratio of the US leading economic indicator to the coincident (now) economic indicator – is “powering” higher, notes Canaccord. This suggests the US economy is not losing but gaining momentum.
Incidentally, a stock market is considered a leading indicator (as it discounts future earnings).
Can it keep on keeping on?
Another warning signal market-watchers constantly point to is the US VIX volatility index. When that index falls to low double-digits, the suggestion is the market has become too complacent and disaster is just around the corner. Recently the VIX has been hitting 9.
But the VIX is not a confidence survey, it simply reflects the demand for options on the S&P500 index. If fear rises, investors hedge their portfolios by buying put options over the index, and this pushes up the VIX. But in today’s market, index put options have become a bit old hat.
There are other ways to hedge positions, and the fastest growing market in recent times has been exchange-traded funds. ETFs have allowed investors to both concentrate their portfolios into sectors they like, and also to hedge via short-side ETFs. To concentrate solely on the VIX is to ignore, once again, market evolution.
(ETFs are a risk unto themselves, but that’s a story for another day).
Morgan Stanley believes the breadth and stability of equity markets in 2017 reflect the synchronous economic recovery and very low dispersion in earnings estimates, not investor complacency. Morgan Stanley is also one of several analysts pointing to a distinct lack of retail investor participation in the bull market to date.
Market-watchers often quote John Templeton – "bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria". The rule of thumb measure of euphoria is when your cab driver starts giving you stock tips. But retail investors remain absent from this market.
Therefore, we have not reached the euphoria stage. Therefore, we are not yet late in the late cycle.
Macquarie believes the global economy has finally moved onto a stronger footing, with above average growth likely to persist over 2018, notwithstanding a slowdown in China. Equity markets will rally further, as the US benefits from tax cuts and continued growth, while Europe, Japan and Australia play catch-up.
But “make hay while the sun shines,” warns Macquarie. 2019 is the year to be worried about.
Research house Lazard expects the ongoing US recovery to last an additional three to five years, assuming there are no exogenous shocks (something no one saw coming, like a missile) or abrupt policy shifts.
Goldman Sachs believes 2018 will be a year of “rational exuberance”, driven by above-trend US and global growth, low, albeit rising, interest rates and earnings aided by US corporate tax reform. But Goldman is on the same page as Macquarie: “One final year of valuation expansion before multiples (PEs) plateau”.
But “plateau” does not mean crash, it just means “not rise any further”. Goldman’s 2018 year-end forecast for the S&P500 is 2850 (assuming tax reform, 2450 if that fails), 3000 for 2019 and 3100 for 2020.
Given ANZ’s economists consider 2017 to have been “serendipitous”, they suggest rates of growth may moderate as 2018 progresses.
Given valuations are becoming stretched on an historical basis, Canaccord suggests “2018 could well be the year when the global equity bull market comes to an end”.
Morgan Stanley suggests the signing of the US tax bill may prompt the final missing ingredient of retail investor participation, thus signalling the end of the bull market is nigh.
It’s way too early to call a recession, says Morgan Stanley, and it won’t happen in 2018, but 2018 may be the year the equity market begins to discount the arrival of a recession in 2019. The broker suggests surprisingly strong economic data and earnings growth will both likely begin to wane in 2018, and global growth become less synchronous.
Putting it all together, the general feeling is 2017 was indeed too “good” to expect a repeat performance in 2018. But overall, the game is not over yet. There is no need to panic.
That does not mean there are no risks.
What could possibly go wrong?
There is much speculation that having so enthusiastically priced in expected US tax reform, Wall Street might just experience a “sell the fact” response when it becomes law. For what else is left to deliver 2017-style upside in 2018?
That would preclude the missing link of retail investor participation, but assuming there is a sell-the-fact response, it may not be too stark given at some point PEs will fall to levels not reflecting earnings upside from said tax cuts and thus the buyers would be back in business.
A greater risk is that despite low inflation, the Fed tightens too quickly. This, too, may be prompted by tax reform, which provides the fiscal stimulus that has been absent in the US since the GFC, thus forcing the Fed to do all the heavy lifting. If the Fed fears inflation will finally jump on lower taxes, it may become too aggressive.
Since 2009, the global economic recovery has been underpinned by central bank policy. It stands to reason that if central banks now reverse that policy, so too must markets reverse.
And it’s not just a Fed story. The ECB is getting close to monetary tightening via QE tapering, if not actual rate rises in the foreseeable future. The ECB, too, could get the timing wrong.
Talk of tax reform takes us to politics. Brexit is still a big unknown. There is still no government in Germany. Catalonian unrest has not yet been extinguished. Italy goes to the polls next year. Congressional mid-term elections are due in the US late in 2018.
Trump the hero may well become Trump the villain in 2018. Riding high on tax reform success, he will feel sufficiently confident to push harder on his protectionist agenda. The US is already out of the TPP. Trump wants out of NAFTA. Many observers suggest a collapse of NAFTA alone would be enough to end the bull market in a hurry.
Then there’s that old chestnut, a slowdown in China. I’m not sure exactly how many years now there have been warnings of a slowdown in China, but it’s definitely several and yet China has sailed on through.
But China’s 2016 growth rate was the lowest in 25 years, the fear-mongers point out, and 2017 could well be lower. Yes it was, down from double digits back in the prior decade when China’s economy was not so much “emerging” as “embryonic”. Imagine if an economy grew at 14% every year ad infinitum. Would we call that “overheated”?
At the same time, 3% global growth is considered healthy. Trump reckons he can get the US to 4%. I suggested earlier in this piece that it’s a bit late now to be calling China an “emerging market”. China’s economy is maturing, and with maturity comes slower year on year growth. What is often overlooked is that 6.6% growth in 2017 is, in actual dollar terms, a significantly larger amount than 14% was back in the early noughties.
There is, of course, the issue of China’s rising debt. Yes, it poses a risk. As was highlighted in 2016, 2015, 2014…
A potentially more worrying risk than China is the global consumer.
As noted earlier, global consumer spending has proven resilient despite low wages growth. How have consumers paid for their consumption? By dipping into savings. Savings rates shot up following the GFC as consumers rushed to pay down debt and lived in fear of another Great Depression. Those rates are now back to where they were pre-GFC.
This leaves consumers in a vulnerable position going into 2018. They have nothing left to draw upon and for the time being, their wages are not growing. In Australia, many consumers are already stretched with regard their mortgage obligations. Rates are set to rise.
If asset rices do tip over, consumers may be forced to back right off yet again.
Is there any good news?
One source of good news would of course be “none of the above”. For they are risks, not realities. In the wider scheme of things, there are some potential positives to consider.
ANZ suggests that for the first time since 2011, there is some prospect of commodity prices enjoying sustained gains. Commodity demand is becoming broader, shareholders are focused on returns (capital management) which limits new investment in supply, China continues to clamp down on excess and polluting supply, and new sources of commodity demand are emerging (batteries, EVs).
And from a technical perspective, commodity price action looks strong.
Credit Suisse notes Millennials are opening up new opportunities for investors. In 2018 the analysts see renewable energy, including solar, wind and energy storage systems, as offering strong prospects. On the other hand, Millennial preference for online shopping will mean continued pressure on the traditional retail sector.
The GFC caused a global slump in corporate capital expenditure, Credit Suisse notes, but capex has been building since that time, albeit very slowly. The broker expects 2018 to see an acceleration in capex, thanks to a combination of strong business confidence and solid profits meeting capacity constraints.
Higher investment boosts economic growth while limiting inflation pressure due to productivity gains, Credit Suisse notes.
US tax reform is also a clear driver of increased investment. Tax reform will provide a boost at a time finance costs are still low and corporate cash levels are high. This suggests corporate M&A, which has already picked up pace in 2017, may well accelerate in 2018.
Assuming all the extra money does not simply end up funding share buybacks, which have underpinned (indeed inflated) earnings per share numbers for the past few years.
And finally, Credit Suisse joins others in pointing to the fact investors are not complacent, as we touched upon earlier. Recent sentiment surveys suggest consensus remains quite cautious, with a large majority of views being “neutral”.
While there are many who can lay claim to “calling” a market crash, most celebrated bears called a crash every year for years as the market rose, only to be finally right one day. No doubt there are those who have indeed got it right (See: The Big Short), but history suggests crashes only occur when no one is expecting them to.
At this stage, analysts see caution, not euphoria.
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