On the Outlook for the Global Economy and Markets; Is a Drink a Day Good for You?

From: aditya rana


The fourth quarter is a good time to start thinking about the outlook for the global economy and markets not just for rest of the year but for the following year and for the following year as well. The independent and well regarded research firm BCA produces a quarterly strategy update which covers the global economy and markets (US, Europe, Japan, China, EM) as well as specific investment ideas, and given their remarkable track-record (turning cautious on global markets in June after being bullish since 2009, bearish on EM currencies and commodities since last year, ending of the US dollar bull run earlier in March) it is advisable to pay due heed to their research. To summarise:

-The global economy is expected to muddle along a below trend pace this year, but should pick-up some steam next year driven by successful efforts by China to reflate their economy and the resulting recovery in EM economies. However, the shortfall in aggregate demand will keep inflation subdued and will keep rates low for years to come.

-US growth is currently averaging 2.3% for the year, which is in line with growth over the previous five years, and looking ahead it is unlikely to deviate much from the 2% rate. While some developing tailwinds should provide support – like the positive impact of lower oil prices on consumption, a normalization of the 30% drop in energy capex spending, and a diminished fiscal drag which has subtracted 0.50% from GDP growth over the last five years (assuming no government shut down later this year). They are likely to be offset by fading tailwinds from loosening in lending standards, improving business and consumer confidence, rapidly rising asset values, zero rates, and finally a normalization of the recession induced pent-up demand (i.e. auto sales).

-The remarkable feature of the US recovery has been that a meager 2% growth rate has reduced the unemployment growth rate from 10% in late 2009 to 5.1% , which based on the pre-crisis relationship should have kept unemployment at around 10%. This is due to the exceptional decline in labour productivity (see chart below) driven by both structural factors (flattening out in the rate of educational achievement, disappointing gains from the latest technologies) and cyclical factors (low levels of business investment, misallocation of labour).

-An enduring feature of the sub-par recovery since the crisis has been the shortfall in demand. While the adverse impact of deleveraging on demand has been well documented, what has been missing is a new re-leveraging cycle to bring demand back to pre-crisis levels. For example, residential investment is currently 3.4% of GDP, and while it may go back to 4%, it is very unlikely to go the pre-crisis level of 6% which means that 2% of GDP has just vanished.

-This fall in demand is unlikely to be replaced by increased consumption (as savings are higher), increased investment (as labour force growth is falling implying less demand for building capacity), increased exports (due to a stronger dollar) or higher government spending (political considerations).

-The possible way out is that rates remain low for an extended period (the above analysis assumes rates move back to pre-crisis levels) which could spur consumption, increase investment in marginally profitable projects made possible by low rates, stronger exports due to a weaker dollar and higher fiscal spending due to low borrowing costs.

-How low should rates be? With short-term real rates averaging only 1% during the previous business cycle (see chart below) when all the above factors were major tailwinds, it is safe to assume that real rates should stay at zero or even negative for the foreseeable future.

-By contrast, Europe with is poorer demographic profile and dysfunctional institutions, will need continued zero or even negative nominal rates to support the economy and the risk is that it may not be able to ease financial conditions sufficiently to prevent a Japanese style deflationary spiral.

-While official forecasts (IMF, European Commission) expect a rebound in the peripheral economies to support European growth, the signs are that this may prove to be difficult. For example, the IMF expects Italian growth to pick-up driven by increased investment by the private sector to offset the increase in government austerity (thereby reducing the debt/GDP ratio) , but this is unlikely given their shrinking labour force and lack of competitiveness, forcing the government to increase spending (and therefore increase the debt/GDP ratio) or face stagnant growth.

-Therefore, the longer term prognosis for Europe implies a resurfacing of the debt crisis at some point, though over the next 12 months we are likely to see a surprise on the upside driven by lower oil prices, a weaker euro, improving credit markets (see chart below which shows the almost perfect correlation between credit growth and GDP) and pent-up demand from the recession.

-Moving to Japan, while the economy faces numerous challenges like a declining working-age population, disappointing productivity growth (output per hour remains 36% below US levels), a high government debt level limiting fiscal stimulus , and a relatively higher vulnerability to EM economies, it is important to note that falling property prices and corporate deleveraging have largely run their course. In addition, Abenomics seems to be working with inflation expectations rising sharply and pushing down real rates by almost 2% (see chart below), and the prime age employment-to-population ratio has risen by 3% and is now 5% higher than in the US.

-EM economies have suffered greatly from an outflow of liquidity this year, a reversal of the massive inflows which took place until a few years ago. A lack of structural reforms during the boom years led to a significant fall in productivity outside of Asia (see chart below) and the credit deleveraging cycle is still in its early stages with Turkey, South Africa and Brazil being most vulnerable.

-Growth in China is slowing down driven by a slowdown in demand for its exports, the government’s anti-corruption drive which has reduced consumption of luxury goods, and as it transitions from a capital intensive export-oriented economy to more focus on consumption and services (see chart below).

-However, policy makers have the tools in place to ensure that the transition does not disrupt economic growth in a significant way. The cuts in rates and reserves seem to have caused a rebound in the housing market with both sales and prices accelerating recently (see chart below). In addition, the fiscal measures to boost infrastructure spending announced recently should add 1% to annual GDP growth over the next three years. On the negative side, the recent mini-devaluation of the yuan was botched as the move was not meaningful enough resulting in capital outflows which offset some of their easing measures. Expect the yuan to depreciate by another 5-8% against the dollar.

-China is likely to avoid a hard landing – firstly, their debt is mainly from state owned banks to local governments and SOEs and arguably these could be netted out as its one part of the government lending to another. Secondly, the housing market has very low debt levels with mortgage debt at 19% of GDP (versus 74% in the US) and loans to developers at 10% of GDP versus 30% in pre-crisis Spain. Even if housing prices fall sharply, the correct analogy would be Hong Kong, which despite suffering precipitous price declines during the Asian financial crisis, saw only a marginal increase in mortgage default rates compared to the US and Spain.

-Claims that China overinvests are also somewhat misleading, as despite the capital-to-output ratio moving higher in recent years it is still lower than it was in the late 70s (see chart below) . This is because the optimal level of investment depends on the growth rate – while China has invested heavily its economy has also grown substantially keeping the capital-to-output ratio in check and well within the range of other countries (see second chart below).

-China is expected to maintain a relatively strong growth rate for years to come driven by its exceptionally high educational attainment level for its stage of development (see chart below). For example, if China’s output per worker were to converge with the level of South Korea by mid-century(currently at 30%), it implies a growth still averaging 7% over the next decade.

Investment implications:

Remain tactically cautious on equities (since June 12, 2015) given the fragility in emerging markets, the uncertainty surrounding a Fed rate hike in December and the collapse in global earnings (see chart below).

-However, remain cyclically bullish (have been since October 2009) using the late 90s as the template, when every major sell-off proved to be a buying opportunity. While some factors differ from the late 90s – i.e. EM are a bigger part of the global economy and DM central banks have less room to cut rates, valuations are much more attractive now with global equities at a forward P/E of 16 (compared with 25 in the late 90s) and at 2 times book (versus 4 times in the late 90s). Europe and Japan are preferred over the US given their more attractive valuations and favourable liquidity conditions. So remain cautious for now and use a 10% or more pullback to increase exposure.

-Remain cautious on EM over the near term and use a further sell-off of 15-20% to add risk. While EM stocks have got cheaper, and trade at a low 12 P/E, this reflects depressed valuations in a few heavy weight sectors like energy, materials and financials, and they still trade at a relatively high median 19 P/E (same for price-to-book). However, the Chinese stimulus should provide a boost to global growth in 2016 which would support the cyclical sectors in EM, and in particular, China H-shares which trade at record low valuations despite earnings and dividend growth which have far exceeded the US over the past decade (see chart below). They represent the single best current trade idea over the long haul.

-US treasuries remain cheap given 10-years at a fair value of 1.5% (with Fed funds remaining in a 1-2% range for reasons outlined earlier and other fundamental reasons), though in the near term they are vulnerable to a sell-off. Typically during past tightening cycles, long rates sell-off during the months preceding the first tightening, then stabilise and actually decline over the cycle. Long treasuries also provide a good hedge against stock market risk, as evidenced by the negative correlation in place since the 2000s which is in sharp contrast to the previous three decades (see chart below).

-The dollar is expected to continue to be range bound against the Euro and Yen while appreciating against commodity and EM currencies for the balance of the year.

Fascinating insights which I broadly agree with. As detailed in last weeks letter, the current uncertainty surrounding the flow of liquidity warrants a cautious approach and the need to raise cash if we do get a rally into year-end, to be redeployed if we get the 10% plus correction in DM equities (and more in EM). Over the longer haul, EM equities (in particular China and India) and currencies provide superior expected returns implying that core portfolios should continue to favour EM assets. The continued Chinese stimulus should also provide good upside to Russian and Brazilian assets in 2016. Perhaps the single most important variable to keep a close eye on in the coming months is the monthly Chinese M2 growth number as it encapsulates the net effect of all the Chinese easing measures (besides being more reliable than other economic variables) which have a significant impact on global markets. As the chart below illustrates clearly, monthly M2 growth dipped to 10% in the summer, the lowest level in more than 17 years, but since then has moved up sharply in the past three months in response to policy measures. Please also note the relationship between falling money supply growth since its peak in 2010, and the slowdown in EM economies (with the US escaping the slowdown due to its QE policy implemented in late 2010). Chinese money supply growth is key – equivalent to $21 trillion versus $12 trillion for the US!

Is a Drink a Day Good for You?

While having a drink a day has been shown to have many health benefits, as the below study published in the respected British Medical Journal shows, it can also increase the risk of breast cancer in women and colon cancer in men. So perhaps exercise some level of caution when reaching out for that daily glass in the event you are at higher risk for these cancers?

PRCM, August 26, 2015:

Cao Y, Willett WC, Rimm EB, Stampfer MJ, Giovannuci EL. Light to moderate intake of alcohol, drinking patterns, and risk of cancer: results from two prospective US cohort studies. BMJ. 2015;351:h4238.

Scoccianti C, Lauby-Secretan B, Bello PY, Chajes V, Romieu I. Female breast cancer and alcohol consumption: a review of the literature. Am J Prev Med. 2014;46:S16-S25.

-Having just one drink per day increases breast cancer risk, according to a study published in the British Medical Journal. Researchers monitored alcohol consumption for 88,084 women and 47,881 men as part of the Nurses’ Health Study and the Health Professionals Follow-Up Study. For women, having just one alcoholic drink per day increased the risk for alcohol-related cancers (mainly breast cancer) by 13 percent, compared with those who consumed no alcohol. Among men, colorectal cancer was the principal alcohol-related cancer. Researchers suspect ethanol and other compounds found in alcohol may be potential mechanisms. Many previous studies have also found that moderate alcohol intake increases breast cancer risk.

Apologies for the delay in the newsletter this week as I was travelling over the last two days (Bon Jovi concert in Macau!). I will be travelling over the next two weekends as well and so the next newsletter will be sent out on October 17.

Here’s to exercising some level of caution regarding even moderate alcohol intake!




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