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Past the peak?

4 May 2018

We wrote last week how we observe that – after the recent correction – stock markets now appear to have entered a consolidation phase, expressed by an unwillingness to rally despite daily announcements of exceptionally strong corporate profit growth. This reached an average annual rate of over 23% in the US this week. We concluded that this may well be because investors are finally coming to notice that global growth is no longer accelerating further and therefore the highest earnings growth levels may also be behind us.

Whether this means that we are past the peak of this very long economic cycle and have entered a terminal downward slope or just experiencing yet another mini cycle within the much larger cycle cannot be determined at the moment. What is mostly consensus, however, is that there are no particular recession indicators on the horizon as there were at the end of 2015, which would point towards a mini cycle.
We took a very extensive look at all the indicators that we and our research providers observe and debated at length what implications the emerging picture should have for the most appropriate positioning of our investors’ portfolios.

2017 will be remembered as the year when regional growth became the most synchronized in history. Given that global growth at an aggregate level had been improving for over ten years, this is perhaps surprising. One might have expected that economies would reach limits of capital and productivity at different times which would lead to growing dispersion.

However, it looks like such dispersion may well have prevailed 18 months ago as we headed into 2016, when emerging markets, and China particularly, hit a decidedly icy stretch of road. The deflation of the commodity bubble, a strong US-$ and a slowing economy in China had led to a substantial slowing of global trade.

China’s early response to weakness in 2015-16 had been to encourage a weaker Renminbi (devaluation). This had bad impacts, with residents trying to get their money out of the country, while Chinese companies that had borrowed in dollars faced increasing financial burden.  The end of 2016 saw the Chinese leadership change their focus, easing monetary and fiscal policy, but wanting to stabilise the Renminbi. This shift markedly improved demand for commodities, while easing dollar liquidity.

Trump’s arrival was the other major event of 2016. His policy mix – fiscal looseness, deregulation, and pressure on trade partners – may not have been obviously beneficial for 2017. However, the delays in fiscal measures meant that while the Fed tightened, it did not do so in a way which caused overall financial conditions to tighten. Personal (i.e. retail investor / consumer) sentiment was strong, leading to an oddity – retail investors increased their risk allocations, and equities saw large inflows. Equity prices rose and, helped by affordable but rising house prices, personal balance sheets improved, which meant that improving wages were channelled into spending. Indeed, the savings rate declined to historic lows.

Meanwhile Trump’s trade policy shift did not result in tariffs immediately. Rather, it was in the interests of both China and the US to see trade improvement through a weaker dollar.  Having expected speedy US company repatriation of overseas earnings, it became apparent that this would be more closely tied to tax changes later. Perhaps more importantly the dollar had reached very expensive levels when measured by “purchasing power parity”. In other words, you could buy more with Euros, Yen and Renminbi than with dollars. The dollar proceeded to weaken throughout 2017.

January this year probably marked the high point for this recovery cycle that started in Q1 of 2016. The benefits of the policy mix ebbed as the policies moved from expectation to reality in the US. The dollar bottomed against most major currencies and then stabilised, as tariffs became a likelihood and US interest rates had been increased enough to increase capital inflows. The substantial US tax cuts started to be reflected in corporate accounts, leading to sharp rises in expected post-tax earnings growth but with expected pre-tax earnings growth levelling and even starting to decline. Retail investors slowed and then reversed their purchases of equities while the tax cuts raised savings rates off the lows rather than boosting consumption further.

In China, economic policy had begun to shift early in 2017 towards monetary tightening but its impacts were complicated. The rise of Xi Jinping to supremacy had a similar impact to that of Donald Trump, with his policies seeking to redress many of the ills which had been created during the unrestrained commerce years. Overall popular sentiment was very positive leading to strong consumer spending. The policy of guiding lending towards the real economy and away from funding the purchase of financial and property assets met with widespread approval. However, the constraint in overall lending meant that infrastructural spending growth started to decline. The general tightness of money raised interest costs and indebted companies started to feel the effects.

All of which leads us to the present day. As the first chart shows, the rate of actual global growth (as measured by industrial production) has plateaued and a leading indicator (as measured by the Goldman Sachs Global Leading Indicator’s momentum) has started to decline.

At a more regional level (as indicated by corporate purchasing manager surveys) we can see that major developed regions peaked either in late 2017 or early 2018, with the difference in timing probably influenced heavily by the bottoming US-$ in early 2018. Some of the surveys are components of the Goldman Sachs Growth Leading Indicator, and are considered to be among the best indicators of the path for near-term real growth.

The long period of aggregate global growth has reduced excess productive capacity – during the last year especially so. Unemployment has declined across the developed and emerging world, with the US rate going below the Federal Reserve’s “non-inflationary” estimate of around 4.2. The measures of industrial utilisation have also stepped up smartly during 2017 to reach levels which have led to increased capital expenditure in recent months. Inflation, which started to increase noticeably in late 2017, typically tends to lag behind growth.

Underlying all of this is another aspect. Money supply growth across the world has been slowing for some time at a nominal level. When inflation is taken into account, it has historically provided another reasonable leading indicator for growth.

The confirmation of this current slowdown which we had anticipated since the end of last year and the negative impact potential this is likely to have on near term corporate profits, causes us to remain cautious over risk assets, as their valuations do not yet sufficiently reflect a slowdown. We suspect that China continues to slow more than the market anticipates, and that Xi Jinping is not as likely to institute the sorts of policy easing that we’ve seen in previous years. We think he will be less inclined to protect private companies from the consequences of overborrowing; the recent downswings in the Shanghai Composite Index may show some credit-related stress and investors suspecting there will be less support than previously hoped.

As a note, Reuters reported Xi’s speech today, “Writing Marxism onto the flag of the Chinese Communist Party was totally correct… Unceasingly promoting the sinification and modernisation of Marxism is totally correct.”

We also think that the factors behind the strengthening of the US-$ are likely to continue, and that the dollar has further to run. As we mentioned at the start, a strong dollar tends to compress global trade. The combinations of factors leaves us slightly more cautious on the South East Asian export powerhouse and their stock markets in the medium-term.

As we stated at the beginning, we are confident that global growth and the world’s economic systems are resilient, and that there is little reason to believe that the global economy is heading for outright recession. A noticeable economic slowdown now has a significant potential to lead to further equity market consolidation, as we head towards the second half of the year. Against the backdrop of sustained global economic growth, this development is likely to provide buying opportunities for the benefit of longer term investment portfolio growth.