Moving towards an investment-led business cycle in 2018
Accommodative monetary policy has been a key driver of global growth over the past eight years. Yet, while 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, economic expansion may be extended.
We expect the key macro theme for 2018 to be a rotation of demand from consumers to capex. Business investment should lift business profitability because the demand benefits feed through quickly and costs can be depreciated over time. Simply put, top-line sales growth can be increased faster than costs,
allowing higher profit margins and increased growth in company earnings.
In an environment of modest wage gains, investmentled growth shouldn’t lead to a material acceleration in inflation. That should mean central banks tighten policy very gradually, if at all. Therefore, 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; and 2) the generalised uncertainty in Saudi Arabia/Iran and possible implications for the price of crude oil, inflation and global growth.
Political risks in Europe and the UK
In the Eurozone, economic momentum is gaining traction in 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 the nationwide ballot, which is due in March 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, 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 divorce 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. Should PM May be forced out, it could lead to a snap election and the real possibility of Jeremy Corbyn
entering Number 10.
The US plough horse expansion
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 6.7 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 in 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 averages1.
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 with tighter US monetary policy.
1 Source: Credit Suisse – Rational Exuberance, 6 November 2017
All values and data correct as of 31 December 2017. Sources: FTSE, Thomson Reuters Datastream, Bloomberg