2017 has been a strong year for equities and an extraordinary year for cryptocurrencies, the ultimate representation of a long-dated asset and beneficiary of cheap fiat money. With inflation still largely absent, and diminutive or negative real interest rates across much of the G10 countries, assets with profits far into the future have rewarded investors handsomely.
The last time the future was rewarded so handsomely was in the late 1990s during the tech bubble. I managed a global technology fund at the time and was finding it increasingly difficult to justify what I had to pay for stocks. Valuations back then were also based on business models that delivered a new paradigm of extraordinary profits far into the future, which is quite challenging when technology is characterised as the archetype of ‘creative destruction’.
It is not an industry known for stability and is replete with titans being rendered obsolete. Valuing anything on distant profits has its dangers, but these dangers increase geometrically when the growth path is based on technology!
The current valuations for technology companies and the bitcoin bubble concern me not because I deny the disruptive appeal or the maths. The valuations are what they are because of a low cost of capital used to discount terminal values, but they only work if there are free cash flows to discount, and the probability of achieving them is high.
Technology/new media stocks have been strong drivers of equity index returns in 2017 and now account for 25% of earnings in emerging markets. Expectations for technology companies are high and if interest rates move up in 2018, some of the Icarus stocks will come under intense pressure. It is unlikely that the other sectors will take up the slack seamlessly to avoid a correction in markets.
Negative interest rates are a powerful opiate and the extremes are not just in equities. European junk bonds now pay a yield equivalent to the US 10-year Treasury bond, and Veolia Environment’s €500 million bond issue yielding -0.02% was four times oversubscribed by investors rushing to lock up a loss in a French BBB-rated company. In Hong Kong, a property on The Peak was recently sold at US$17,000 per square foot, and Leonardo da Vinci’s Salvator Mundi sold for US$450 million to the Abu Dhabi Department of Culture and Tourism.
It is no surprise then that the flood of year-end forecasts are repeating the mantra and caution of the past five years, focusing on the prospect of higher interest rates driven by higher inflation. This is an annual event that Einstein might say is more like madness, as we look for a different outcome to the same structural debt and deflation problems.
One reason it may be not be so mad is that central banks are slowly recognising that it is not necessary to keep injecting liquidity into the system. The global economy is in very good health and output gaps are falling around the world. The deflationary impact of emerging market labour has probably peaked and tighter liquidity could prevent asset valuations from overheating.
However, the evidence to support an outright inflationary view is not overwhelming and any inflation out there is hiding behind the headlines. Headline US core inflation is a paltry 1.4% but German wage inflation is 4.6%, Japanese real wage growth is 2.1% and the Atlanta Fed Prime Wage growth number is 3.7% (see below chart). Chinese producer price inflation is about 7% and oil is up 10% year on year (yoy).
In the US, healthcare and shelter are the two most significant core components of inflation and both appear to be trending lower. Broad commodity prices are also down 5% yoy on average. This implies that the probability of an inflation shock is quite low despite the underlying strength of the economy.
Labour appears to have minimal pricing power and disruptive technology is the new deflationary dynamic. Therefore, although there are some inflation warning flags, it would appear quite likely that interest rates will stay low by historical standards and keep the long duration asset trade ticking along.
The strength of the global economy is a double-edged sword for investors. Higher growth leads to higher earnings and the rise in equities this year has been principally driven by 16% higher global earnings.
However, GDP growth can also lead to the real economy absorbing more of the excess liquidity in the system, via higher investment and working capital, to effectively crowd out financial money flows.
Lower tax rates in the US should incentivise investment in capital assets as we approach optimal capacity utilisation but generally we expect crowding out will largely be offset by stock buybacks, and for next year’s US equity returns to broadly reflect the 12% earnings growth currently factored in. Multiple compression may dampen returns more than in 2017, and could become a more serious issue if inflation surprises on the upside, but tax reforms will be supportive to earnings.
Next year the UK is forecast to see one of the lowest growth rates in GDP (1.6%) and corporate earnings (6.5%) as a result of a tapped out consumer and diminishing investment flows. Capital flows into the UK are under pressure from the threat of a Corbyn government and of course Brexit, both of which introduce additional volatility to the outlook via the exchange rate.
Our base case at the moment is that sterling will remain cheap or will weaken relative to the US dollar and euro, and investors should consider reducing exposure to the UK.
Earnings growth in Europe in 2018 is expected to be a healthy 12%, and profit margins are forecast to widen by 1-2%. However, in our view European Central Bank (ECB) policy is too loose and the risks of a policy surprise are rising.
European bond yield curves would steepen quite significantly if this were the case and some term premium would quickly be restored to the long end of the UK and US bond markets. Higher interest rates may unsettle equities in the short run but a steeper yield curve will benefit the banks and is unlikely to suffocate growth.
It is very difficult to see how the Federal Reserve can raise rates four times in 2018 to 2.5% and for interest rates in the Eurozone to remain unchanged. If it becomes clear that the ECB should close the yield gap by raising rates, and it fails to do so, currency flows to the US dollar will accelerate – and a higher US dollar would impose significantly tighter monetary conditions on growth in the US. A strong US dollar is the antidote to global growth and, although this is a non-consensus call, we believe portfolios should have some US dollar exposure just in case.
A strong US dollar as a result of higher interest rates would be particularly bad for emerging markets. These broadly depend on excess US dollars to fund both the 5% real GDP growth expected next year and their current account deficits.
One offsettting positive is that savings rates in emerging markets are low and declining, while savings in developed markets are high and rising. This suggests that money will seek higher investment returns where capital is in short supply, and that interest rates in the developed world will remain low. Therefore, emerging market currencies should at least hold their own – if not appreciate – relative to the US dollar.
Idiosyncratic risks obviously abound in the diverse pool of countries that make up the emerging market category. But our central view is that earnings will continue to be strong (+12%) in 2018, and that the broad emerging market currency basket will appreciate. We remain positive on emerging market equities and local currency debt.
Year-on-year growth comparisons looks more favourable for Latin America and less favourable for China, where structural shifts are likely to slow growth modestly in the first half of next year.
The 19th Plenum in China was important for three reasons. It made it clear that the authorities are determined to curb the financial risks lurking in the shadow banking system, that there will be strict capacity and production restrictions in basic industries to improve financial performance and the environment, and that speculation in the property market will be targeted with increased scrutiny on the misuse of consumer loans for downpayments and an increase in building permits to improve supply.
The Party and Xi Jinping appear determined that “houses are built to be inhabited, not for speculation.” Emerging markets are therefore likely to be driven by earnings growth but, like the broader market, we would not be surprised to see a significant shift in the drivers of performance.
In summary, our outlook for next year is worryingly indistinguishable from the consensus. Financial assets are expensive but equities continue to be an attractive option. Fixed income is far from a safe haven, although investment grade credit and emerging market debt offer reasonable but more volatile returns in a strong global economic environment.
Politics in the UK also creates enough uncertainty, in our view, to increase the global element of portfolio exposure while being cognisant of the increase in implied currency risk.
In all probability, with valuations where they are it is highly unlikely that the year will pass without an equity correction to test our fortitude. We would not be overly concerned if this happened, as it is relatively normal and would not change our positive view on equities, but we are focused on inflation and a strong US dollar as more structural concerns.
I wish you all a happy and rewarding New Year.
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