Wednesday, May 8th, 2019
The surge in equity markets in 2019 is caused by many macro factors acting in unison. In no particular order, we observe across the world readings of low inflation, low but steady growth, supportive economic policy settings, low interest rate settings, maintenance of QE and the expectation (soon) of a trade resolution between the US and China.
Most important is the interaction and growth observed in the US and China. Today, these two powerhouses have adopted pro-growth economic settings through highly stimulatory fiscal policies. While debt is growing in these two economies, it is supportive of world growth and equity markets have focused upon this in 2019.
Our first chart from Capital Economics shows the current level of economic growth across the world’s major economies (the G7 – ex-China).
Figure 1. GDP in G7 Economies (% YoY)
Source. Capital Economics
The standout economy is the US, whose growth reading for the March quarter – released last week – was an annualised 3.25%. It was above expectations and led to all-time records for the S&P500 and Nasdaq indices. Importantly, this growth is occurring with no uptick in inflation and with a steady positive reading in consumer sentiment. The burgeoning US fiscal deficit is not in focus as yet, but it is also a contributor to US growth.
Elsewhere, and particularly across Europe, growth is subdued and incremental growth is declining. In Japan, the economy is slipping again and Italy is drifting in and out of recession. German growth is very subdued and is currently (and remarkably) outpaced by both France and the United Kingdom. Brexit is supposedly bad news for the UK inside Europe, but the current economic readings suggest that the opposite is the case – at least on a relative basis.
Economic activity and growth flow through to unemployment. The following chart shows that unemployment rates are actually at quite reasonable levels (except Italy and France) given the tapering of growth.
Each of the US, UK, Germany and Japan exhibit strong employment trends. However, the tepid population growth rate in Japan remains a major concern and an ageing workforce masks the underlying employment problem shown by a declining worker to retiree ratio.
Figure 2. Unemployment Rate (%)
Source. Capital Economics
Our next chart introduces China and the rest of the world into economic growth. Clearly, the world’s incremental growth is substantially driven by that of China, the US and a rapidly emerging India (hidden inside the ROW below).
Figure 3. Contribution of Countries to Global Growth (in percentage points)
Source. IMF, World Economic Outlook; and IMF staff calculations
The above chart confirms that Europe and Japan barely add to incremental world growth. This supports our contention (published in recent editions of The View) that negative or low interest rate settings are not a panacea for poor economic growth.
To this point, we note that the Reserve Bank of Australia is currently being coerced by many economic commentators to cut the official Australian cash rate from its current 1.5%. While the recent reading for inflation in the March Quarter was nil, we believe that the RBA will not be so quick to cut rates and nor should they be.
The evidence is overwhelming (from observing Europe and Japan) that excessively low interest rates actually damage growth. Importantly, it is also observable that rising interest rates in the US through 2017/18 corresponded with a lift in economic growth. Those that argue for lower interest rates have little evidence to support their position.
The significance of China’s growth as a percentage of actual world growth is presented in the next chart. Since the turn of the century, China’s growth contribution has lifted from just 2% to over 16% of world growth.
Figure 4. China’s Share of World GDP (%)
Source. Refinitiv, Capital Economics
Debt continues to grow
The other support for economic growth has been growing debt. However, the sustainability of burgeoning debt is difficult to prove with the ultimate unwinding and the associated cost simply unquantifiable. However, we can readily observe that the growing debt across the developed world (particularly the G7 – ex-China) has been and continues to be supported by the central banks’ maintenance of low interest rate settings and large balance sheets.
The next few charts from the Bank of International Settlements focuses on the growth of debt since the GFC and identifies the major economies where it has occurred. It makes for interesting reading.
The first chart focuses on Government debt and shows the extraordinary growth in the US, where Government debt has grown at twice the rate of GDP. In Europe, the growth in government debt has been much more moderate – but so too has economic growth. While in China, government debt has grown from about 20% of GDP in 2008 to 50% of GDP today.
Figure 5. Government debt
Source. Bank for International Settlements
In the advanced world the growth in debt, outside the US and Europe, is dominated by Japan – whose gross debt to GDP is approximately 240%.
A different observation of debt is seen when Corporate (i.e. non-financial) debt is perused across the world. In this segment, the growth in Chinese debt over the last ten years is astronomical.
Figure 6. Non-financial corporate debt
Source. Bank for International Settlements
The sustainability of this type of debt is subject to much conjecture, for it reflects the significant amount of non-bank and “unregulated” lending inside China (or “shadow lending”). Many commentators claim it is a ticking time bomb, while we take the alternative view that it will in time be dispersed back into the formal financial sector to be properly regulated. Its growth reflects the immaturity of the Chinese banking system during a time of immense growth.
Meanwhile, Chinese household debt is low compared to the US (75% of GDP) and indeed Australia (110% of GDP). This is unsurprising, and reflects the immaturity of China’s social security safety net – thus households build savings to guard against uncertainty. Over the coming decade, it would be reasonable to expect Chinese household debt to rise to a similar percentage of GDP to the US while corporate debt will decline.
Figure 7. China Debt (% of GDP)
Source. CEIC, WIND, Bloomberg, Capital Economics
Our view on the debt make-up inside China is drawn from the next chart, which compares per capita economic production (GDP) to that of the US, and in China’s case, makes a prediction (courtesy of Capital Economics) for 20 years’ time.
Figure 8. GDP Per Capital as % of US Level (2017)
At about 15% per capita of that of the US, there is only one way that Chinese economic growth can go – and that is upwards! Corresponding with rising per capita growth will be both rising per capita income and debt. The growth of China will, in turn, ensure world growth continues – no matter what Europe or Japan does.
This prediction is based on the continuation of the growth of world trade and the significance of China in exporting deflation to the world. While both these assumptions have come under recent challenge, their continuation as long term structural shifts remain the logical call.
The next chart is instructive because it shows that as China’s export growth has grown, a downward pressure on inflation, right across the world, has been created.
Figure 9. G7 Inflation & China’s Share of World Exports (%)
Source. Refinitiv, CEIC
The significance of Chinese growth and the importance of a resolution in the China-US trade negotiation is easy to comprehend. Chinese growth has ensured world growth with low inflation has endured. It has also allowed debt across the world to grow with maintenance of lower and lower interest rates.
The significance of Chinese trade is also captured in its capital account. While the Chinese capital account peaked (as a percentage of GDP) prior to the GFC, it remains positive today despite a growing services deficit created by tourism and education. There has also been a growing supply of capital from the ROW to China and this is seen in the appearance of a negative income balance as China pays interest to foreign creditors.
Figure 10. Breakdown of China Current Account (% of GDP)
It is the open flow of capital that ensures that world growth continues and it is the growth in debt across the developed world that has maintained economic growth with a circular growth cycle evolving.
Importantly, it seems that world economic growth is likely to endure for quite a while. The combination of world growth, low inflation and low interest rates have combined to lift equity markets and added to balanced portfolio returns after a poor December 2018 quarter.
From this point, we see “more of the same” in terms of the macro environment, but we suspect that equity returns will slow somewhat as equity markets have work to do (i.e. grow corporate earnings) following on from such a strong rally.
We are neither bullish nor pessimistic on the world outlook, and the rally in equity markets is explainable by the interplay of macro factors. From this point, we believe that a strong quality-biased and valued-based investment approach is needed to identify and access opportunities in this world of low growth.