A favourable backdrop for stocks overall
September proved to be a month where records and cycle highs were set. According to index provider MSCI, global equities rose for the 11th consecutive month, equal to the longest unbeaten run set in February 2004. In Developed Markets (DMs), the US S&P 500 and tech-heavy Nasdaq indices traded at peaks towards the end of the month. Equity performance is broadening to Emerging Markets (EMs) too, where stocks are up 25% so far this year, the best return since the post-Global Financial Crisis rally in 2009.
Behind these market performances, there is increasing evidence of a synchronised global economic recovery. For the first time in seven years, the International Monetary Fund projects that real GDP growth will accelerate in both EMs and DMs in 2017. Demand is picking up in DMs from ongoing employment gains and the wealth effect stimulus on consumption from rising asset prices. Meanwhile, EM demand growth is benefiting from Chinese structural reforms to use the market more effectively in the allocation of financial resources. Looking forward, both DMs and EMs are transitioning to self-sustaining growth. This increases the probability that the global expansion will last for longer, even if geo-political risks lurk on the Korean peninsula.
Separately, companies are becoming more profitable. The S&P 500 operating profit margin is at a record high, as major companies have been adept at keeping labour costs down. If labour fails to negotiate higher wages from corporates, profit margins are likely to remain elevated. There are structural reasons to believe that labour is unlikely to regain pricing power anytime soon. Advances in telecommunications technology enables companies to parcel out service-sector jobs to areas with high unemployment, where wage rates are typically low. Faster broadband speed allows businesses to outsource back offices from major to minor cities, or possibly overseas. Job search apps or websites such as LinkedIn, also make it easier to match job offers with applicants to reduce frictional unemployment.
The lack of labour pricing power is a global phenomenon. Take the UK and Japan, where labour markets are tightening. Even though the UK employment-to-population ratio is at all-time highs, wage growth has decelerated to just 2% year-on-year, from near 4% in 2015. In Japan, the job offer-to-applications ratio is near a 45-year peak, but average regular cash earnings are barely growing at all. The bottom-line is that an enlarged labour pool limits the pricing power of workers and enables big business to boost profit margins.
This favourable backdrop probably explains why equities have been able to shrug-off a new cycle of monetary tightening by major central banks. Starting with the US, the FOMC last month announced its intention to stop reinvesting all of the money it receives when Treasuries and mortgage-backed securities mature, but with caps added to reduce the risk of a sudden withdrawal of liquidity from the financial system. Over in Europe, the ECB is set to taper asset purchases, while the Bank of England has brought forward expectations of a rate hike. Considering that inflation is running below central bank mandates, monetary tightening is expected to be gradual.
Global stocks have proved robust, in the face of political uncertainty. Although Angela Merkel secured a 4th term as German chancellor in the September federal election, it was not a great result for her party. Merkel’s CDU/CSU union had its poorest showing since 1949, while its junior government coalition partner, the SPD, fared no better and said it would now go into opposition. The biggest winner was the far-right AfD party, which entered the lower house for the first time to become the third largest party in parliament. This indicates that populism remains a risk to the political establishment in Europe.
Given the seat distribution in parliament, Merkel’s only realistic option to govern is to link up with both the business-friendly FDP and the Greens to form a so called “Jamaica” coalition, named after the colours of the Jamaican flag. The inclusion of the FDP in the coalition, which is strongly opposed to EU integration, runs the risk of creating uncertainty over EU support for economies in the periphery of Europe.
The German election also has potential implications for Brexit. While David Davis and Michel Barnier are negotiating deal options, they are getting no firm guidance from Berlin on which direction to pursue and are unlikely to receive any until a German government is established. Coalition talks may be difficult again this time around, as a Jamaica coalition combination has never been tried in federal government. A delay would have implications for Brexit, since it would shorten the time available to finalise a deal on the UK’s divorce and transition from the EU. It remains to be seen how European leaders will respond to UK PM May’s recent speech on Brexit in Florence. Considering that the UK is in the uniquely difficult position of having the widest current account deficit and lowest real yields out of the world’s major economies, it will be difficult for sterling to rally far, even if market expectations for higher UK interest rates in November have intensified.
The MSCI All Country (includes DMs and EMs) stock market index reached a new high in September. So far this year it is up 15%, driven by double-digit gains in both DMs and EMs. Looking further back, the MSCI All Country index is up 181% from its previous cycle low in March 2009, when central banks actively became involved in propping up the market through QE. The current rally compares to a 152% rise from trough-to-peak during the last stock market cycle between October 2002 and October 2007.
The US 10-year government bond yield is currently trading at around 2.3%, which is below its peak this year of 2.6%. Bond yields have been anchored down by lower-than-anticipated inflation in 2017, as well as less certainty that President Trump can pass a tax reform and fiscal stimulus package through Congress. On the latter point, Republican leaders unveiled a new tax blueprint towards the end of September. If bond yields are to rise further from here, the market will need to see signs that the probability of a tax package passing Congress looks likely.
FX and commodities
The gold price has remained in a fairly stable range over the past few years, but it could potentially rise further from here. That’s because China is increasing efforts to offer oil exporting countries Renminbi (the Chinese currency)-denominated contracts for oil that can be converted into gold. Recently, the Shanghai
Futures Exchange and its subsidiary Shanghai International Energy Exchange completed some preparatory tests in order to list Renminbi crude oil futures. Renminbi-backed oil and gold futures would allow oil exporters to bypass benchmarks that are denominated in US dollars. Considering that Renminbi oil contracts would be paid in gold, it could appeal to energy producers that are subject to US sanctions, such as Russia and Iran, and increase demand for gold.