5 September 2018
The global economic backdrop favours equities over bonds
Global growth is strongly influenced by the US, the world’s largest economy. The current US economic cycle is now into its ninth year, the second longest expansion since records began in 1854. However, just because the cycle is historically long it does not necessarily follow that the expansion is approaching its end. That’s because the normally cyclical parts of the economy (e.g. expenditure on consumer durable goods and business fixed investment) have lagged the recovery. Indeed, the economic recovery since the Global Financial Crisis (GFC) in 2008 has been the slowest since the Second World War. Essentially, the US has swapped economic vigour for longevity.
Importantly, there are less obvious signs of imbalances in US private consumption, which accounts for 70% of the economy. The US statistics agency recently revised up its estimate of the personal savings rate to 7.2% of take-home pay from its previous estimate of 3.3% in the first quarter, largely due to significantly stronger incomes than originally thought. Much of the upward revision came from the last 18 months, and this could reflect more complete data from annual tax returns for 2017 that showed employment income was higher than expected. In short, the data shows that there is financial wherewithal to sustain consumption growth at current rates.
Separately, there are now signs that US corporates are beginning to invest more in plant and equipment. In the second quarter, annualised non-residential fixed investment expanded by a healthy 8.5%, as tax cuts and President Trump’s deregulation agenda start to kick-in. Not only should that increase risk-appetite, but it should boost company earnings, as company top-line sales are raised. It is worth noting a record 84% of US S&P 500 companies beat Earnings Per Share (EPS) estimates in the second quarter financial reporting season.
Moreover, despite US monetary tightening, global real interest rates are still low and accommodative for growth. Fiscal policy is also becoming more conducive for faster economic activity. For instance, the US is implementing its largest tax cuts since the Reagan administration in the 1980s and China, the second largest economy, has recently begun to ease both fiscal and monetary policy to support its economy.
Assuming that corporates are able to sustain relatively elevated profit margins during this ongoing expansion, it would be reasonable to expect global equities to track consensus Global EPS growth expectations of around 10% on average per year for both 2019 and 2020. Based on a fairly benign inflationary environment and a gradual reduction in ultra-loose monetary policy by the major central banks (Fed, BOE and at some point in 2019, the ECB), our expectations are that equities will continue to outperform conventional bonds.
The key risks to equity markets are: i) a sharp pickup in inflation that forces central banks to tighten policy more aggressively and stifles global growth; and ii) an escalation in trade protectionism that leads to competitive currency devaluations. Nevertheless, our central scenario is that these risks are contained.
Crunch time for sterling
The outlook for sterling will be dependent on whether the UK government is able to secure a “soft Brexit” deal with the EU or not. While Michel Barnier, the European chief negotiator for the UK’s exit from the EU, has said 80% of the Withdrawal Treaty (WT) has been agreed, there are four major outstanding issues, namely; i) the Irish border question; ii) the role of the European Court of Justice in resolving disputes over the governance of the WT; iii) the link between the UK’s future trading relationship with the EU and the divorce settlement; and iv) the ability to extend the WT beyond the end of 2020.
Considering the febrile political environment, it will be difficult for the British government to make the likely required concessions to deliver an agreement with the EU on the withdrawal terms. Moreover, time is running out before the EU Council Meeting (18/19 October), to agree the WT and a political declaration on the future UK-EU trading relationship.
With MPs due to come back to parliament after the summer recess on the 5 September, domestic politics are once again set to influence the sterling exchange rate. Should Prime Minister May fail to unite the party at the upcoming Conservative Party Conference (30 September to 3 October), it could lead to a leadership challenge or a confidence vote in the government. The Democratic Unionist Party could also pull out of the confidence and supply agreement with the government if it feels Northern Ireland is going to be treated differently than the UK as part of a deal with the EU. That would deprive the Tories a majority in the House.
Looking forward, we see sterling as being vulnerable to downside from EU and domestic politics. This increases the need to diversify to overseas’ markets from sterling-denominated assets.