Thursday, July 5th, 2018
The financial year 2017-18 started with exuberance as the tailwinds of both low interest rates and low oil prices supported world economic growth. The talk of a trade war was considered a low risk with President Trump homing in on tax cuts as his core economic priority.
Now as we reach the end of FY18 the risk of trade wars have come to centre stage. The US equity market, buoyed by tax cuts, has now stalled as higher US interest rates, a higher USD and the real risk of trade dislocation (affecting US multinationals) becomes a reality. Just yesterday, Harley-Davidson announced it would move some production of its iconic motorbikes out of the US to avoid retaliatory European tariffs imposed last week.
The OECD in November 2016 warned of the consequences of a “tit for tat” 10% adjustment to tariffs. They suggested the biggest loser would indeed be the US and global GDP would be negatively impacted by 1%.
Figure 1. Estimated impact of 10% tariff increase
Source. OECD Economic outlook, November 2016
Over the weekend, Europe has retaliated against the US with tariffs on $3.3b of US imports and the EU and China have come together to consider further responses. July 6 is looming when the specified $34b of additional tariffs kick in with the threat of another $200bn from the US side should China retaliate, which they did.
There were threats yesterday, reported in the Financial Times, pointing to restrictions being imposed by the US Administration on investment from China in US technology companies – an announcement is expected in days. Specific restrictions by the US on Chinese investment are apparently designed to prevent Beijing from moving ahead with plans outlined in its “Made in China 2025” report to become a global leader in 10 broad areas of technology, including information technology, aerospace, electric vehicles and biotechnology. The Treasury Department is reported to be crafting rules that would block firms with at least 25% Chinese ownership from buying companies involved in what the White House calls “industrially significant technology.”
A trade war or dislocation is serious enough but more so in this era as it comes at a time when equity markets (most notably the US S&P500) have just traversed its longest bull run since the Second World War.
Figure 2. Longest S&P 500 bull markets in history
Given that equity markets have sustained a ten-year long (post-GFC) rally, much commentary revolves around both the risk of a market correction and the size of that correction (if and when it comes). Based on historical precedents, the chance of losses akin to the 2008 GFC event (greater than 30% loss) is just 3% (1 in 30). A market correction (decline) is ordinarily a 1 in 4 chance over the long-term but is now a heightened risk given the ten year period since the GFC.
Figure 3. S&P 500: Historical probability of a loss
Source. Richard Bernstein Advisors LLC
The near 10% market correction in January – February 2018 for the S&P500 needs to be considered in assessing the risk of a further market correction in the near-term.
Figure 4. S&P 500 index
Source. Thomson Reuters Datastream
Nervousness concerning market valuations is coming at a time when world central banks have little in reserve in terms of manipulating interest rates to support their economies. The European and Japanese Central Banks have overplayed their stimulatory monetary settings.
Last week the European Central Bank indicated their intention to begin reducing their quantitative easing (QE) program in the last quarter of 2018. Their intention is to create a sanitised QE whereby interest and bond redemptions are reinvested but the effective printing of money to purchase bonds ceases. Concurrently, the ECB retained their interest rate settings with the base cash rate at minus 0.4%.
With the ECB not joining the US Federal Reserve in adjusting cash rates, we continue to see a headwind for long-term bond yields to rise significantly. The “risk-free” rate of return, generally taken as the ten-year bond yield, sits at near multi-year lows. In fact, European yields have generally rallied following the initial shocks surrounding the risk of Italy pulling out of the Euro currency.
Supporting the world economy has been the constrained rise in oil prices. Again over the last weekend, OPEC met to lift oil supply to the market in an attempt to extract the maximum return for its members against the threat of US production and new technology. The advancement of new energy technology will be hastened should oil prices leap ahead.
At this point, an oil price of about US $70 seems to satisfy a range of interests.
Figure 5. Brent crude oil ($US/barrel)
The recent lift in the USD has sheltered the US economy from the rise in oil prices – it has not translated into inflation. The US household is paying less for gasoline than they did in 2014.
Figure 6. 48-month average retail price chart
The risk of trade dislocation and concerns regarding the growth of unregulated debt in China has dented their various equity markets. The Hang Seng, Shanghai and Shenzhen markets have all taken a tumble approaching 10%. In recent days, the Chinese Administration has loosened monetary policy and slightly increased liquidity for banks.
Figure 7. Market indices
Source. Thomson Reuters
But the unrelenting march of IT supremacy continues with US technology companies (dominated by the FAANG stocks) becoming larger than many equity markets and economies around the world. As an interesting aside, the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) have a combined market capitalisation of US$3.2 trillion; the ASX in total has a market cap of US$1.5 trillion. In terms of trade retaliation, the world awaits a significant response from Chinese authorities to check this growth through IP regulation and tariff walls.
Figure 8. Region size by market capitalisation
Source. BofA Merrill Lynch, Datastream, MSCI
Success measured by profitability and therefore market valuation has resulted in a dramatic change in the makeup of the top ten companies in the world over the last decade. The decline of telcos and energy companies is plain to see. In the world top ten, only Microsoft and ExxonMobil have maintained a position. The likes of GE, AT&T, China Mobile and BP have lost relative ground. The emergence of Google and Facebook in the US, with Alibaba and Tencent in China, show the emergence of IT as the premier growth sector.
Figure 9. World’s 10 biggest stocks as percentage of the MSCI ACWI Index
Source. BofA Merrill Lynch, GIS, Datastream, MSCI
With IT success and burgeoning equity valuations has come the growth of mega wealth across the major western economies and China. The wealth created by investment-compounding capital is on display in Japan – an economy that has struggled for decades and yet the wealth of its mega-rich continues to grow.
Figure 10. HNWI Population Growth
However, mega wealth creates its own societal and ethical issues; fairness demands a degree of re-distribution and the development of a just and healthier society. Despite its economic success – measured by sustained economic growth and a surging sharemarket – the US lags its peers in life expectancy. Recent data suggests the trend in US life expectancy has begun to fall – a terrible outcome in an era of medical advancement. It has fallen for the last two years in a row – down to 78.7 years, which puts it behind the OECD life expectancy average of 82.3 years. The primary causes: substance abuse (opioids and alcohol) and suicide.
Figure 11. Life expectancy in years
The United States equity markets (measured by market capitalisation) represent about 55% of the world market (size US$47 trillion). Therefore, its daily direction drives equity market sentiment every day.
Figure 12. World bond and equity market weighting by market capitalisation
Source. BofA Merrill Lynch, Datastream
The significance of IT in driving the US index return is shown below. In 2000, the Nasdaq was an outlier where valuations greatly exceeded the ability of companies to ultimately earn profits. Since 2008, the surge has been supported by earnings, but the recent lift in PERs has not sufficiently discounted the risks of trade dislocation – particularly with China.
Figure 13. S&P500 sectors market cap %
Comparing the makeup of the US market above with other world markets is interesting – particularly Australia, which has huge exposures to banks and financials. Indeed Australia’s financial system exposure is clear to see in the following table. It is arguable that because Australia ducked the full weight of the GFC, our financial sector blossomed under extraordinary monetary policy support.
Figure 14. Banks as a share of total local market (%)
Source. Absolute Strategy Research
As noted above, the yields on global long-term bonds are still are historically low levels. The US ten year bond has traversed the following path over the last year – today’s yield is just 0.5% above the average yield of a year ago – the fear of a bond collapse has not been realised.
Figure 15. US 10-year Government Bond
Source. TradingEconomics.com, US Dept. Treasury
The resounding and sustained strength of the US economy is best shown in the following chart which captures a remarkable coincidence. Not since 2000 have there been more job opportunities opening up than there were unemployed workers. The chart shows why the unemployment rate has fallen from a peak of 10% in 2009 to a low 3.8% today.
Figure 16. US unemployed workers vs. job opening level
Source. Bureau of Labor Statistics
The US economy is undoubtedly strong and this has led to both the growth in US corporate earnings and the percentage of earnings to GDP. The recovery from the GFC and the immense assistance to the economy by both fiscal and monetary policy saw profits surge. The recent tax cut will see corporate earnings again approach all-time highs as measured against GDP (about 10%).
Figure 17. US Corporate Profits as a percentage of GDP
Source. Richard Bernstein Advisors LLC., BEA