Economic Outlook for August
Calendar year 2018 has certainly been a volatile and more difficult environment for investors than 2017. A strong and steady rise in markets in January was cut short by the sudden implosion of long volatility products, causing a shock drop in equity markets in February. Equity markets recovered into March, before testing those previous lows again in April. The ongoing trade war rhetoric from an erratic US administration has pushed geopolitical risk back up the agenda. Meanwhile the true impact on markets from a normalisation of monetary policy remains unknown. Given the experience through 2018 investors would be right to be thinking about whether or not to maintain equity exposure. Despite the volatile year so far, likely continuation of uncertainty, and higher volatility, we continue to see the outlook for equities as being positive. Specifically we continue to see long-term structural growth trends as being the ideal position for equity investors. Long-term structural changes in the global economy, like the orbit of the moon and tides of the sea, are changes that will not be stopped, either by short-term economic cycles or equity market declines. These fundamental changes to the global economy are being driven by new technologies, changing demographics, urbanisation and emerging markets. Investing in these trends should, by definition, offer investors an optimal long-term exposure to growth and strong long-term investment returns.
Finding pessimists is never difficult, particularly when discussing the outlook for equity markets. Whether it is nascent inflation risk, or even hyper-inflation risk, an imminent market crash, China-crisis, dollar implosion (or explosion), or any other reason to buy gold, these predictions of doom are nothing new. What these offer is less a cogent reason to exit equity markets, and more an example of a simple factor underlying all market analysis. The world is unpredictable: unexpected things happen, and the future cannot be perfectly predicted. After a strong equity rally and period of good returns, it is no surprise the calls for imminent disaster grow louder. Any of these things could happen, that’s true. But they are all inherently impossible to predict accurately. Any one of these risks could happen tomorrow, next week, next decade… or never at all. Their unpredictability makes them un-investible, you cannot predict their timing, or even occurrence. In our view, investors should focus on what they can predict.
The exuberance of past market peaks that preceded crashes is not evident now in equity markets, indicating a crash is not likely to happen soon. Meanwhile Trump’s tax cuts are boosting US economic growth, economic activity in Europe is strengthening and remains strong in China. The ongoing trade issue is currently having no measurable impact on activity. At least for now, the trade war remains more jaw-jaw than war-war. Corporate earnings growth remains strong and outlook positive across all major sectors of the global economy. The structural growth drivers of new technologies, emerging markets, and a changing world continue to support growth in stocks exposed to these trends. These are things we do know, and in our view this makes a recipe for strong future performance in equities with exposure to these structural trends.
The Only Game in Town
Government bond markets continue to have more in common with a post-apocalypse than a modern free-market for securities. Central banks still dominate the purchases of new issues in Japan and the Eurozone. We see negative real yields on new government debt issues, while at the same time those same issuers reach record levels of debt-to-GDP ratios. Structurally lower economic growth in many Southern European issuers further adds to the despair facing bond markets. Growing political uncertainty in the Eurozone and currency volatility will only add fuel to that fire. From the perspective of investors today, the abnormalities of the bond markets make them, arguably, un-investible. Equity valuations may be higher today than in much of the recent past, but times are different now. Debt markets are not just overvalued, but at all-time price highs (all-time yield lows). Interest rates haven’t been lower in 5,000 years of recorded history. This doesn’t sound like a good time to invest in bonds!
In the absence of a massive economic crisis, equities are arguably the only game in town for investors. Interest rates in the US are rising, as are bond yields, and this will only push bond prices down. Rate rises have been interpreted by many as bad for equities, however we see this as an incorrect interpretation. Rate rises are happening because central banks see the economy as being strong enough to take them. This is a good indication for equities. There is 10x the capital in bond markets as there is in equity markets, a lot of space for new capital inflows into equities. Rather than current equity levels being the top of a market cycle, the abnormalities of the post-2008 crisis period in bond markets could see a positive inflection for equities to reach much higher levels.
Trade War Update: No China-Crisis… Yet
The data coming out of China continue to show strong economic activity. China electricity consumption in June expanded +8% YoY, maintaining the high growth run-rate seen through Q2 and a solid indicator of sustained higher activity in the Chinese economy in 2018. The China Satellite Manufacturing Index for July posted another strong reading, no change MoM and significantly higher YoY, indicating sustained strong levels of activity in manufacturing in China in July. Export trade data was solid for June, with +3% YoY increases in CNY and USD terms, maintaining the growth rate seen in April and May. Where we may be seeing some short-term impact from the trade issue is in confidence levels in China. New PMIs (confidence surveys) released for the major sectors in the Chinese economy paint a more mixed picture for near-term outlook. The Service sector PMI posted a strong reading in June, up strongly YoY and MoM to 53.9, indicating strong expectations of expansion in this sector of the Chinese economy. The steel, construction, transportation, machinery, automotive and home appliance manufacturing sector PMIs all posted a decline in June, to levels indicating expectations of contraction. These are the weakest readings we have seen in these metrics since 2016. Looking at the activity level indicators and PMI readings together what we see is evidence of strong underlying economic activity continuing in China, however there has clearly been a deterioration in outlook in the manufacturing sector in recent months, this is likely as a result of the US-China trade dispute escalation. Although we are not currently seeing any impact on activity, we are seeing a short-term impact on confidence in the Chinese manufacturing sector.
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The views expressed in this article are those of the author at the date of publication and not necessarily those of Dominion Fund Management Limited. The content of this article is not intended as investment advice and will not be updated after publication. Images, video, quotations from literature and any such material which may be subject to copyright is reproduced in whole or in part in this article on the basis of Fair use as applied to news reporting and journalistic comment on events.