Asset Class: International Equities

A bumpy December has investors asking “Is this the beginning of the end?”

international equities is this it banner

Maybe. The Dow is down 5.6% for the year (13.4% from its high); FTSE 100 down 12.5%; Toronto Composite down 11.6%; German Dax down 18.3%; French CAC 40 down 10.9%; Japan’s Nikkei 225 down 12.1%; Australian Stock Exchange 200 down 6.9% and China’s CSI 300 index down 25.3%.1 So, yes, we’ve had some decent falls but with the exception of China and possibly Germany they are barely sufficient to rattle the teeth.

We’ve been expecting and talking about the inevitable asset price correction for so long that it is probably foolhardy to suggest that this is the big “IT”. But if this isn’t the beginning of the end perhaps it’s the beginning of the beginning of the end.

The President of the United States is directing his invective at the Federal Reserve (Fed) but his ire is erroneous and mistimed. We’re no fans of central banks — regular readers will be aware of our frequent criticisms — but to upbraid the Fed for finally doing what is absolutely essential is to ignore the perilous debt-financed asset bubble that has emerged since the financial crisis. The central bank trillions have enriched the favored few but not the many and have done little to stimulate economic growth.

Recent OECD data indicates that in the first quarter of 2008, the balance sheet of the Fed amounted to 6.1% of GDP. It topped out at 25.4% in the fourth quarter of 2014. It is now steadily sliding thanks to deliberate shrinkage and is down to (a still hefty) 20.4%. In the eurozone, the European Central Bank balance sheet kicked off 2008 at 15.9% of GDP and topped out at 40.0% in the third quarter of 2018. The ECB is now ending quantitative easing so shrinkage should commence in earnest in 2019. The Bank of Japan started at 20.9% of GDP in 2008 and is yet to top out as its version of QE continues apace. At present, the balance sheet amounts to a whopping 99.1% of GDP.

So there you have it: unprecedented and extraordinary levels of monetary stimulation that have ended, are ending or will soon end (unless the BOJ decides to purchase the entire stock of domestic government securities — it is currently the proud possessor of around 45% of issuance). We have omitted reference to the Bank of England because, in terms of trillions, it is a mere minnow. The key point is that global credit is now contracting following a decade-long spell of extraordinary expansion accompanied by negligible interest rates. It is a sea-change that is yet to be fully appreciated by the markets.

Despite all the fervent stimulation, the economic recovery since 2009 has been the weakest in the last 70 years. If measured in terms of GDP growth, labor productivity, fixed capital formation, consumption or employment, the answer is the same. Employment data in the U.S. tells the story. The U.S. is now at “full employment” if government statisticians are to be believed, but up until almost eight years after the start of the 2007 recession, the employment outcome was inferior to all others — and with the exception of the 2001 recession, that remains the case. The problem with the recovery from the 2001 recession was that after six years, it bumped into the global financial crisis.


So where to now? It is our judgment that equity markets remain overpriced — in some cases considerably so. The U.S. stands out as possibly being the most overvalued despite the recent mini-correction. Based upon our forecast rate of long-term potential real GDP growth of 2% the market should fall as much as 50% from its 2018 high to reach what we regard as fair value. But that will be considered an outrageous suggestion as the view remains that everyone from the Fed to Uncle Tom Cobley will throw everything at the market if the slide begins in earnest. And they’re probably right, but sometimes even Uncle Tom Cobley has trouble stopping a rout.

Another (lack of an) update on Brexit

We remain in the dark when it comes to knowing where this extraordinary saga is heading. The Prime Minister is trying to cobble together parliamentary and EU agreement for a deal that will maintain Britain’s position in the Customs Union and bound by all the various EU rules but without any involvement in setting those rules. That makes no sense to us. Many in British politics (and the EU) are pushing hard for a second referendum — if you don’t like the result of the first, have a second or third until you get the result you want. It’s an interesting take on democracy.

The British people voted to opt out of a union that has the ultimate goal of a federal state — the United States of Europe. This agenda has never been secret or disguised. It is pertinent, however, that Europe’s third largest continental economy, Italy, has now moved decidedly into the eurosceptic camp. At the same time, Germany is weakened by a Chancellor in her last term with rapidly fading electoral support while President Macron in France is battling violent protests on the streets over his fiscal agenda. In other words, Europe is a long way from presenting itself as a welcoming and harmonious whole at precisely the time Britain self-harms as it wrestles with the EU dilemma.

It seems that no one will come out of this with credit. The bitterness and rancor will continue for a long time, but hopefully as the dust settles, whichever way it goes, the British economy will gather itself and move on. It has the potential.

Australian house prices – finally falling?

It is no fresh revelation that house prices in Australia – particularly in Sydney and Melbourne – have streaked to astronomical levels. If measured in terms of median price to median household gross income they are simply unaffordable. Only Hong Kong shades them on those metrics – although Vancouver isn’t too far away. But now, finally, gravity is asserting itself. A combination of restrained credit availability, excessive leverage, increasing supply, fewer foreign buyers, threats to negative gearing, general economic uncertainty and simple exhaustion are having an impact.

According to the Australian Bureau of Statistics Sydney prices fell by 1.9% in the September quarter and 4.4% in the year to September. Melbourne prices were down 2.6% and 1.5% respectively. Prices in Sydney commenced their fall in the September quarter of 2017 – down by 1.4% in that quarter.


More up-to-date data supplied by private survey groups suggest the price decline has steepened. For example, the CoreLogic group claims the Sydney median house price was down 8.9% in the year to December and 11.1% from its peak in July 2017. In the 1989-1991 period Sydney prices fell by a record 9.6% so it appears that the record has now been broken. Melbourne prices are claimed to be down 5.8% in the 12 months to December and 7.2% since their peak in November 2017. The median house value in Sydney is now AU $808,495 whilst the Melbourne median value is AU $645,123. Perth and Darwin have suffered far more with cumulative falls of 15.6% and 24.5% since their respective peaks.

Housing in Australia is a sacrosanct topic. To suggest that prices may fall is to be considered a fifth columnist – or at best, simply foolish. Everyone owns their few square meters of paradise and that is their nest egg that must do nothing but go up in value. Of course a great many have taken it much further and used negative gearing to buy a property investment portfolio that is their path to great riches. Negative gearing is a perfectly legal rort whereby Australia’s diminishing supply of net taxpayers help fund that path to riches – provided, of course, that prices continue to rise. And that is clearly a very significant “provided”.

We simply look at the fundamentals. The Australian public (and the banks) are extremely leveraged into property at a time when real income growth is static and the personal savings ratio is plunging (8% in 2014, 5% in 2017 and in the September quarter this year just 2.4%). On an international scale householders top the indebted list – relative to disposable income.


Moreover, many Australians entered into interest-only loan arrangements for a period of (usually) five years – after which they revert to principal and interest. The bulk of these arrangements run-off between now and 2020. That will financially stress many borrowers.

In terms of the relationship between median incomes and median house prices Sydney values should fall by around 50% from their 2017 peak – and that would only take them to the equivalent of current prices in New York or Seattle (based upon median income and price data). Of course a fall of 50% is another one of Pyrford’s outrageous suggestions as it would result in an extremely severe recession in Australia. But fundamentals are fundamentals. If things get too far out of whack in one direction they need a period of adjustment in another. The tiny percentage to-date falls are just that – tiny. We expect bigger things.

The demographic challenge

We have often reflected upon the startling changes the aging population will have upon the world – and particularly the developed world as that is where the issue is most acute. Simply stated, the declining share of the total population “in work” will lower economic growth at a time when the budgetary demands on governments and retirement systems are under most stress.

In a recent publication the IMF projected that by 2035 the number of people in low-income countries reaching working-age (15-64) will exceed that of the rest of the world combined. That startling statistic is depicted in the graph below.


The implication is that the strongest growth will be in the low-income countries (no surprise there) whilst the developed world will struggle along with productivity growth and not much else. Take a look at China on the chart – it suffers from an even greater demographic challenge over the next 30 years than the developed world. It has finally removed the one-child-per-family policy but indications are that Chinese couples have simply lost their appetite for large families. This is no different from the trend we see throughout the world.

Aging populations are expensive. They consume rather than contribute. They make demands that society finds it difficult to fund and manage. It is a challenge that we know about well in advance but little is being done to prepare – politicians will always leave these and similar long-term challenges to the next in line whilst many in society choose to simply ignore the financial challenges of their retirement years.

The IMF comments that the low-income countries face pressure to accommodate the rapid increase in the working-age population. In a sense it is a high-class problem but being realistic the IMF states that: “Creating enough jobs to absorb the new entrants will be vital for welfare and social and political stability. In this regard, economic diversification into labor-intensive activities outside agriculture, and away from excessive dependence on commodities for resource-intensive exporters, is critical…improving education standards will be essential to ensure that the growing pool of workers has the necessary skills.”

So whichever lens you look through there are difficulties ahead – funding the ageing population in a low-growth developed world and finding sufficient jobs for those in the low-income world. It wasn’t meant to be easy.

Sweden: The cashless society

There is a push by governments in many parts of the world to substantially reduce cash transactions. It is considered the most effective way of defeating counterfeiters and fraudsters, limiting other illegal activities (such as burglaries and tax-evasion) whilst reducing costs and providing more precise control over monetary affairs. But we hadn’t realized that it had gone quite so far as it has in Sweden. According to a recent report in the Times of London less than 1% of the money changing hands in Sweden utilizes notes and coin. This compares with 3% in Britain, 10% across Europe and 85% around the world.

Apparently a mobile payment app called Swish overtook cash for the first time this year. Some techies have even gone so far as to implant tiny radio transmitters beneath their skin so that they can pay their bills with their hands.

So is this the future? Yes, it probably is although it will take many years for cash to disappear. There are many in society who struggle with the digital world although their numbers will steadily diminish. You only need to examine your own circumstances relative to 20 years ago to appreciate how much the digital payment mechanism has been embraced. Your correspondent is old enough to remember when weekly or monthly pay-packets contained actual cash!

We have no problem with the gradual elimination of cash. The challenge for governments is, as always, to stay one step ahead of the cyber-criminals who will relish the challenge of hacking into a world wholly based on digital transactions. Some will claim that staying one step behind is about the best that can be hoped for. Let’s hope they’re wrong.

China decelerating

The world’s locomotive is slowing. Recently the Bank for International Settlements reported: “The Chinese economy gradually decelerated throughout the year as authorities pressed ahead with a deleveraging policy aimed at keeping financial stability concerns at bay. The pronounced downturn in stock prices, which deepened in October, tightened financial conditions further through its impact on equity-backed loans.”

At the same time the currency has been depreciating both against the US dollar and many of its emerging market competitors, putting pressure on official interest rates in countries such as Indonesia, India, Pakistan, the Philippines, Turkey and Argentina.


The National Bureau of Statistics in China reported at the end of December that industrial profits fell 1.8% in November from a year earlier. This was the first decline since December 2015. The decline largely reflected slowing growth in sales and producer prices as well as rising costs.

China helped pull the world out of the global financial crisis with extraordinary levels of capital investment. We know now that much of that investment was wasted. No doubt you will have read about (if not seen) the “ghost” cities in China. Leverage has rocketed and the pay-back is meager. IMF calculations suggest that China’s non-financial private sector debt has risen from 114% of GDP in 2008 to a meaty 210% in 2017 (see below). The same source indicates that general government gross debt has risen from 27% of GDP in 2008 to 51% in 2018.


We doubt that China can play such a prominent role the next time around as it has fired many of its bullets. The problem is we can see no ready replacement.

The final word

Rarely have we reached a year-end with so many clouds of uncertainty hovering. Equity markets are jumpy after a peerless 9-year run. We’ve just had a look at the Dow Jones index and apart from a tiny 2.2% decline in calendar 2015 it has been ever-upwards since the end of the financial crisis – until the pronounced stumble in the last 12 months. The one-way bet is no more. Even the President’s twitter- fest has done nothing to calm the nerves. Perhaps the opposite.

Ultimately it comes down to valuations. You will get tired of us saying it but equity valuations have been stretched – and stretched again. They and bond markets have enjoyed a Rolls Royce ride on the back of central bank trillions. The same central banks are now driving beetles.

The trade war is not helping to calm nerves. Recent calculations by the OECD indicated that if the tariff tit-for-tat between the US and China proceeds as planned it could cleave around 0.8% off world GDP by 2021 (relative to the OECD’s baseline forecast), just over 1% off US GDP and around 1.4% off China’s GDP. Consumer prices in the US in 2020 would be around 0.6% higher than otherwise. Now where’s the sense in that?

We have no idea what will happen in 2019. It could be calamitous as many cross-currents converge in an unhappy fashion. Or the world may muddle through as it often does.

Cash was king in 2018. It rarely happens two years in a row but it is not without precedence.

And on that note we wish all our readers a very Happy New Year.


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FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. The equities use an investibility weighting in the index calculation. The S&P/TSX (Toronto Composite) Index is the headline index for the Canadian equity market. The S&P/TSX composite index represents about 70% of the total
market capitalization on the Toronto Stock Exchange (TSX). Deutsche Borse AG German Stock Index (DAX) is a total return index of 30 selected German blue chip stocks traded on
the Frankfurt Stock Exchange. The equities use free float shares in the index calculation. CAC 40 Index is a modified cap-weighted index of 40 companies on the Paris Bourse. NIKKEI
225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. S&P/ASX 200 measures the performance of the
200 largest index-eligible stocks listed on the ASX by float-adjusted market capitalization. Representative liquid and tradable, it is widely considered Australia’s preeminent benchmark
index. The index is floatadjusted. The CSI 300 is a capitalization-weighted stock market index designed to replicate the performance of top 300 stocks traded in the Shanghai and
Shenzhen (China) stock exchanges.The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip U.S. stocks. Investments cannot be made in an index.

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