Economic Outlook for December 2017
A drop of more than 1% of the NASDAQ index on November 29 reminded investors that the relatively low volatility in equity markets this year cannot be expected to last indefinitely without occasional spikes of uncertainty. The drop also comes after a very strong performance of technology shares year-to-date. For long-term investors it is important to look through the noise that typically accompanies weak equity markets and address the following question: to what extent have long-term prospects changed?
As investors are approaching the end of a highly profitable year for global equities, the economic backdrop remains supportive for corporate profit growth: commentators seem to project global profit growth similar to this year (high single digit) and with economic prospects in all major economic regions either remaining robust (China), or showing some acceleration (US and Europe), there do not seem to be any dark clouds on the economic horizon globally.
Equity valuations have of course advanced in the course of the year but the equity risk premium remains in attractive territory with the exception of the US equity market, where the positive effects of tax reform have been discounted to some extent. Increased volatility in equity markets could create attractive investment windows for long-term investors intending to benefit from the favourable economic backdrop.
Growth in China remains solid
Some short-term indicators of the Chinese economy signal some tempering of high activity levels; underlying trends, however, continue to show solid economic growth. Property sector data continues to show a hot residential housing market in China with continued high levels of activity and price rises, this reassures many observers who typically view the property sector as potentially vulnerable to a slow-down. The data of key lead indicators (PMIs) for October, on the other hand, showed what appeared to be seasonal slowing in activity. More data would have to be assessed before one can have more conviction on whether recent trends signal seasonality or more sustained signs of tempering of activity levels. For now at least one can conclude that incoming evidence continues to show strong underlying activity.
The Global Shopping Festival (Singles Day) held on November 11 suggest that the Chinese consumer is not in a mood to temper its spending habits as Alibaba announced that sales at this event had risen by 42% year-on-year hitting $25.4bn and became the largest shopping event globally. The consumer is likely to remain the most important driver of the Chinese economy (and by implication the world economy) notwithstanding occasional volatility in other indicators with respect to the short-term economic momentum.
The International Monetary Fund (IMF) suggested in a recent publication that authorities should consider shifting policy efforts towards an improvement in the quality of economic growth by reforming state-owned enterprises and reducing the dependence on credit growth. Related to this, economic growth targets should not play the prominent role they have at the moment. The authorities are currently targeting GDP growth of around 6.5% for this year, compared to 6.7% in 2016. China's economy has, however, been surprisingly strong so far this year recording a 6.9% increase over the first nine months. So, any policy-driven tempering during the fourth quarter would still be consistent with the government’s growth strategy.
US tax reform progressing slowly
The political drama surrounding the political process related to the proposed US tax reform became a major factor influencing investors’ sentiment towards the end of November. For equity investors the main component remains the proposed cut in corporate taxes by 15% to 20%, which would boost corporate profits potentially by 23%. Another important element is the tax on the repatriation of overseas profits, where the proposal calls for a 5% tax rate for illiquid assets and 12% for cash.
At the end of November, a key subject for the Senate is how future fiscal deficits would have to be financed if underlying growth assumptions (and therefore government revenue generation) fall short of projections. Rating agencies have been critical with respect to the risks to US government debt resulting from the tax plans. According to Fitch the tax reforms would only offer a short-term boost to the US economy but would add to government debt over the long-term fiscal outlook, raising the debt/GDP ratio to 120% by 2027.
Equities do not rise in a “straight line”
Investors have been discounting the tax benefits on several sectors as political negotiations progressed. It was therefore understandable that any suggestion of complications in reaching a political compromise dented the confidence in US equity markets to varying degrees. In addition the strong rally in technology stocks made this sector a prime candidate for profit taking now that the end of the record-breaking year is within sight. In addition, the initiatives regarding net neutrality have also contributed to rotation out of the technology sector. However, while legislative changes do create real effects, this pullback does not seem to be extraordinary. An analysis of the NASDAQ performance (a proxy index for the technology sector) reveals an average 6% decline from the largest peak to trough in the fourth quarter each year.
Whilst swings in equity markets create periods of poor sentiment for growth sectors such as technology, it is important to distinguish between structural shifts in economic fortunes and temporary effects. Temporary rotations within equity markets in and out of growth sectors do not alter the long-term case for growth investing (at a reasonable price) but investment portfolios of growth stocks tend to be more volatile. Fund volatility can, at times, be relatively elevated and risk management tools are aimed at managing volatility, but shifts in market sentiment and sector preferences cannot always be predicted. A relative de-rating of growth equities happens during periods of increasing optimism regarding cyclical economic factors; by definition, however, these economic fluctuations do not persist and cyclical sectors tend to under-perform the wider market over longer periods. Growth stocks, on the other hand, benefit from their “long duration” profile: investors can look far into the future regarding the earnings potential of these companies and tend to use the discounted value of long term earnings (and cash flow) streams as a valuation yardstick. As a result, valuations of growth equities tend to be at a premium compared to market averages.
In the current environment of the normalization of interest rates (led by the FED in the US) the discounting of future earnings will, in itself, result in lower discounted values (due to a higher discount rate). This is, however, only one aspect of the economic backdrop: as the earnings trend is positive and, more importantly, the improving clarity of monetary policy resulting from the normalization process should encourage investors to extend the investment horizon further into the future; increased confidence benefits the risk taking propensity of market participants. It is also worth emphasizing that monetary tightening is reactive to synchronized and accelerating global economic growth (and the related positive earnings momentum). On balance, higher earnings and increased risk taking can be expected to out-weigh the (delayed) effect of rising interest rates into 2018.
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