Economic Outlook for October 2018
Investors are entering the last months of a volatile year with significant swings in sentiment triggered by such issues as trade-tensions and developing market currency routs. These changes in sentiment have driven price fluctuations in the equity market and investment funds (including the Dominion Global Trends Funds), meaning that single investment entry points have subject to the short-term effects of this volatility, something that can be lessened by spreading investments over multiple entry points, while comparative effects lessen with time. As stated a number of times over the past year, it is important for long-term investors to look through the noise that typically accompanies equity markets and address this question: to what extent has the long-term outlook for equities fundamentally changed? As investors are approaching year-end, the economic backdrop remains supportive for corporate profit growth: commentators seem to project global profit growth similar to last year and with economic prospects in all major economic regions remaining robust (except for a number of Latin American and Middle Eastern countries) there do not seem to be many dark clouds on the economic horizon.
During the third quarter of 2018, the S&P 500 rose an impressive 7.2 % whilst the Nasdaq showed a similar increase of 7.1%. The Dow Jones rose slightly more than 9%. Equity performances were driven by favourable quarterly earnings trends with second quarter profits for S&P 500 companies increasing by 25% according to FactSet.
Equity valuations have shown further increases in the course of the year but the equity risk premium remains within a normal range with the exception of the US equity market, where the positive effects of tax reform have been discounted to some extent. Some caution is therefore warranted but volatility in equity markets also tends to create attractive investment windows for long-term investors intending to benefit from a favourable economic backdrop. There is no logical reason to adjust our favourable view of global equities.
China likely to remain dominant
With US trade measures starting to be felt, and in light of recent policy measures by Chinese policy makers, the assessment of short-term economic prospects, although invariably positive long-term, has become more complicated. In its most recent Economic Outlook (from July 26) the IMF reviews a number of critical economic factors in the Chinese economy, which are likely to determine the economic outlook over the coming 18 months. The IMF points out that China currently represents around one third of global growth as it states, “over 800 million people have been lifted out of poverty and the country has achieved upper middle-income status.” The IMF urges the authorities to continue with its reform efforts and “fix the roof while the sun is shining”; this means that credit growth has to be brought under control and that the role of market forces have to become more prominent. Encouragingly, the IMF thinks that even with some slow-down in growth China is expected to become the world’s largest economy by 2030.
The Chinese government is adjusting its policy priorities to high-quality growth and de-emphasizing the overall growth number whilst encouraging structural reforms, in an effort to reign in credit growth and attempt to follow a sustainable economic development path. There are some tentative signs that policy adjustments are having an effect: although the government states that credit growth remains too fast, the corporate debt to GDP ratios has shown some recent signs of stabilization.
In assessing the sustainability of the favourable Chinese economic trend, structural factors play a crucial role. If the strong economic tailwind is used to implement reforms and reign-in excesses the economy would be in a position to sustain the momentum. One should probably not project a smooth “straight line” transition to a diversified high-tech service economy but the potential is significant: the IMF points out that China has around 700 million internet users and according to the IMF 282 million “digital natives”, which are internet users younger than 25 years. For observers of the Chinese economy it does not come as a surprise that China is now regarded as a leader in Ecommerce, fintech and robotics. The IMF recommends a rebalancing of the Chinese economy away from traditional sectors and address the strong reliance on heavy industry; the optimal implementation of these new policies would imply less inequality, reduced pollution and more emphasis on education.
Overall the IMF economists expect 6.6% GDP growth this year with some downside risks to the projections due to tighter regulations and some weakening in exports (although the effects of US protectionists trade measurers are still difficult to quantify). The IMF economists would prefer more decisive reforms of regulations and state-owned enterprises and a shift towards an investment-driven economy.
Favourable economics vs. political drama
The political dramas in the US have led to some compelling TV programming but have had only a limited effect on share prices. It is safe to assume that equity prices would be higher if US politics would have been less fierce but investors have to recognise that the US tax reforms are a positive factor for equities – so the “what if” scenario is somewhat flawed. The upcoming US congressional elections also have the potential for political fireworks but, judging by market reactions to recent political events, one should not be surprised if equity markets remain firmly focused on corporate trends.
Investors have been discounting the tax benefits on several sectors as political negotiations progressed. It was therefore understandable that any setbacks in the politics of providing fiscal continuity temporarily dented US equity markets in varying degrees in the third quarter. 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 has been coming within sight. It is also the case that the initiatives regarding net neutrality have contributed to the temporary 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.
Swings in equity markets create periods of poor sentiment for growth sectors such as technology, and 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 normalisation of interest rates 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 clarity of monetary policy resulting from the normalisation process continues to improve, investors should be encouraged 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 further rising interest rates into 2019.
In order to apply economic concepts in a systematic manner (and to maximize the practical application of economic theory), it makes sense to analyse valuation measures at regular intervals applying a consistent methodology. A popular method is to compute the equity risk premium (ERP), which indicates what the premium is that equity investors demand in order to invest in (risky) equities rather than risk-free assets. A high ERP indicates that equities are relatively cheap and vice versa. Often the methodology developed by Aswath Damodaran from the Stern School of Business is used for this purpose (it is a long time series that is published regularly). Currently his ERP stands at 4.68% (data from September); this suggests neither an obvious over- nor under-valuation of US equities.
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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.