Accommodative monetary policy has been a key driver of global growth over the past eight years. Yet, while the economic expansion has broadened, output growth rates have been fairly lacklustre.
For example, US annual real GDP growth since 2009 has averaged around 2% in what is the weakest post-war recovery rate. However, slower growth may increase the duration of the business upswing, as it reduces the risk of imbalances in the economy. So while the US business cycle is one of the longest on record, it doesn’t necessarily mean it will end soon. That’s because capital expenditure (capex) has lagged the recovery so far. By returning to more traditional drivers of the business cycle, like capex, the economic expansion may be extended.
We expect the key macro theme for 2018 to be a rotation of demand from consumers to capex.
Since the benefits from capex are felt quickly through higher overall demand growth, and costs can be depreciated over a lengthy time period, capex should lift business profitability. Simply put, top-line sales growth can be increased faster than costs, allowing higher profit margins and faster growth in company earnings.
In an environment of modest wage gains, investment-led growth shouldn’t lead to a material acceleration in inflation. That should mean central banks tighten policy very gradually, if at all. Steady growth in company earnings and relatively easy monetary policy should underpin further gains in equity prices from current levels.
Global market risk largely revolves around;
1) UK and Eurozone political uncertainty;
2) the generalised uncertainty in Saudi Arabia and the possible implications it could have on the crude oil price, inflation and global growth; and
3) whether US lawmakers can pass tax reform and tax cuts through Congress.
Political risks in Europe and the UK
In the Eurozone, economic momentum is gaining traction heading into 2018. Although the fundamental picture looks broadly favourable for Eurozone stocks, the political outlook is uncertain. In Italy, the pro-European PD party came third in the recent regional Sicilian election, in what may be a dry run for a nationwide ballot that is due before May 2018. More concerning is evidence of some polarisation of German voters following last autumn’s general election. The Grand Coalition of the CDU/CSU and SPD now controls 56% of seats in the lower house of parliament (the Bundestag), down from 80% in the previous election in 2013, and the authority of Chancellor Merkel looks to have been damaged after the poor performance of her party in the election.
The UK economic and market outlook is intertwined with Eurozone political developments. The longer it takes Germany to establish a government, the less time there is for the UK-EU to finalise Brexit departure terms, a pre-cursor to holding trade talks. Domestically, PM Theresa May’s position looks vulnerable, and she appears to be struggling to stop Tory party infighting over Brexit. Should PM May be forced out, it could lead to a snap election and the real possibility of Jeremy Corbyn entering No.10 Downing Street.
The US plough horse expansion
The US economic expansion can be likened to a plough horse. While the recovery is slow, there is hidden strength underneath. First, rising net household wealth (currently a record 6.6 times take-home pay) from increasing asset prices and employment gains supports consumption.
Second, the corporate profit share is currently at a historically high level relative to the last 50 years. And third, after years of rebuilding capital, banks can now extend credit to borrowers. With tax reform and cuts on the horizon, the outlook for the US economy looks reasonably constructive.
We expect the strengthening economic backdrop to raise company capex plans. Typically, the positive feedback loop between the macro economic backdrop and capex is associated with strong gains for company earnings and markets. A study published by Credit Suisse on 6 November 2017 found that in seven periods of capex-led growth since the 1960s, the S&P 500 stock market index and company earnings rose at an annualised pace of 8% and 15%, respectively, higher than the long- term averages .
While US market valuations are elevated versus historical averages, it is worth noting that since the market troughed after the Global Financial Crisis in March 2009, Earnings Per Share have accounted for around two-thirds of the increases in the
S&P 500 price performance. As such, current market valuations reflect the ability of US companies to deliver on analyst earnings’ expectations and should not necessarily be feared by investors, even if Fed tightening and the flattening of the yield curve pose some risks to the recovery.
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