Asset Class: International Equities

An uneasy October for global equities

It may not pass a statistical test but it does seem that October often brings on a case of severe wobbles in global equity markets. The years 1929 and 1987 are two infamous examples and whilst October 2018 doesn’t come close to measuring up to those debacles it nevertheless has caused serious investor palpitations.

Pinning down the exact reason for the nosedive is a waste of time as there is no “exact reason”. Inflexion points and abrupt changes in market sentiment often occur without precise cause. There are, of course, various issues causing nervousness: the Trump trade skirmishes; slowing growth in China; quantitative tightening; firm inflation; oil; Brexit; political and policy uncertainty throughout the European Union plus the usual swag of country specific issues – Iran; Turkey; North Korea; Russia; Argentina; Venezuela; Pakistan; Saudi Arabia et al….

To the above list we would add something far simpler – overvaluation in many equity markets. The U.S. stands out as a market that has, in our view, enjoyed significant overvaluation. It has ridden on the back of Trump spending initiatives, tax cuts, record stock buy-backs and some extraordinary rhetoric (mainly by the President). The “independent” Federal Reserve is, we believe, doing precisely the right thing (albeit a bit late) by raising rates and shrinking its balance sheet at a moderate pace and it is concerning to see these sound moves being vociferously attacked by the President. The growth “bump” in the U.S. will steadily subside to its sustainable long-term trend rate of around 2% per year – a rate that is not compatible with recent stock market valuations.

The IMF, in its latest World Economic Outlook (WEO), has endeavoured to quantify the potential magnitude of U.S. budget deficits over the next few years. It forecasts the Federal deficit to amount to 4.7% of GDP this year and 5.0% in 2019. By 2023 it expects the negative annual gap to remain sizeable at 4.5% of GDP. The consequence is that the ratio of gross public debt to GDP keeps rising – forecast by the IMF to be 117% of GDP in 2023 – whilst new bond issuance needs to be maintained at a vigorous rate in order to fund the “gap”. In this money-sucking environment interest rates will experience steady upward pressure.

The IMF is relatively down-beat in its latest forecasts: “Global growth is forecast at 3.7% for 2018-19, 0.2 percentage points below the April WEO projection, and is set to soften over the medium term. Global financial conditions are expected to tighten as monetary policy normalises; the trade measures implemented since April will weigh on activity in 2019 and beyond; U.S. fiscal policy will subtract momentum starting in 2020; and China will slow, reflecting weaker credit growth and rising trade barriers. In advanced economies, marked slowdowns in working-age population growth and lackluster productivity advances will hold back gains in medium-term potential output.”

In a refreshing display of self-analysis the IMF has examined the accuracy of its forecasts between 1991 and 2016. It reports:

“Whilst the average country in the sample [of 117 economies] experienced 2.7 recessions during 1991-2016 out of the 313 recessions…only 47 have been anticipated. Even for 2009, the year after global output shrank when Lehman Brothers collapsed, only six advanced economies (and no emerging market and developing economies) had been predicted in the October 2008 WEO to enter into a recession; subsequently, output was estimated to have contracted in 56 (almost half) of the economies in the sample. The accuracy in predicting a switch from positive (or zero) to negative growth has been even lower: only nine out of 212 “new” recessions were accurately forecast between 1991 and 2016.”

Lest you think that the IMF is alone in having a pretty terrible forecasting record it reports that data from Consensus Economics reflecting the average of private forecasters’ expectations for 44 economies reveals a very similar pattern of forecasting errors. Between 1991 and 2016 actual recessions occurred 62 times in Advanced Economies but private forecasters only anticipated 6 – an accuracy rate of just 9.7%.

In these pages you will never find specific recession (or boom) predictions. Now you know why.

Bank of Canada raises benchmark rate

The Bank of Canada has raised its overnight benchmark rate to 1.75%, the third upward move in 2018 and fifth since 2017. It also announced that it expects, in the near future, to completely remove monetary stimulus from the economy. Another rate hike in December is possible whilst two or three more appear likely in 2019. Thus the global trend to tightening is confirmed. The significant exception remains Japan – isn’t it always?

Italy and the eurozone: One size fits none

Italy is endeavouring to buck eurozone rules by expanding its budget deficit to a maximum of 2.4% of GDP in an effort to generate some self-sustaining growth. The problem is that gross public debt already stands at 131.8% of GDP (IMF data). The yield on Italy’s 10-year bond has more than doubled since the beginning of the year to around 3.4%. The banking system remains fragile with a capital “F”. Thus we inevitably return to the fundamental flaw of the eurozone – one size fits none. Germany has spent the last five years paddling along with annual budget surpluses when it, of all eurozone countries, can afford to provide bloc-wide stimulus by running a deficit. Good luck getting current German leadership to change that policy. Italy needs a deficit to provide modest stimulus together with a flexible monetary policy and a more competitive exchange rate. Throw in some public debt cancellation and the economy might stand a chance. Without these measures there is virtually no chance. And that is the sad legacy of the eurozone – an artifice that the history books of the future will mark down as a failed economic experiment.

German Chancellor, Angela Merkel, has announced that her current term in office, her fourth, will be her last following decisive set-backs in the regional elections in Bavaria and Hesse. The junior partner in her fragile “grand coalition”, the Social Democrats (SPD), was particularly battered by the voters. The Greens and the far-right anti-immigrant party, Alternative for Germany (AfD), both polled well. Ms Merkel has also announced that she will step down as leader of her party, the Christian Democratic Union (CDU), this coming December. So we are left with the curious situation in which she will be Germany’s leader (until 2021) but not the leader of her party beyond the end of this year. This may not be sustainable.

Germany, traditionally the epitome of stability and the only reliable ‘glue’ in the eurozone is now suffering the same voter-fate as many other countries. Ms Merkel’s long drawn-out exit can be expected to provide all sorts of political pyrotechnics as leadership jostling intensifies.

Shifting fortunes

In one of its recent missives the OECD reflected on the dramatic change in the geography of the Fortune 500 largest companies in the world. In 2000, 179 of the 500 were headquartered in the US and just 10 in China. In 2017, 132 were in the U.S. and 109 in China. Japan has seen its numbers shrink from 107 to 51. These are probably the most dramatic changes in the 63-year history of the Fortune 500. 75 of China’s 109 (69%) are State-Owned-Enterprises (9 of the 10 in 2000) but ongoing economic liberalisation is likely to see the percentage in private hands continue to increase.

An additional OECD analysis indicates that since 2005 China has invested U.S. $1.1 trillion in foreign companies (investments of U.S. $100 million or greater). North America has soaked up U.S. $224 billion and the European Union U.S. $298 billion. Countries participating in the “Belt and Road” initiative have received U.S. $278 billion. China is not going away.

In case you missed it Dyson (of vacuum cleaner fame) has announced that it plans to manufacture electric cars in Singapore. It expects to roll out its first model by 2021. Singapore may seem like an odd choice for a vehicle manufacturing base but little that Dyson does fits the normal mould. It revolutionized the technology and design of vacuum cleaners and has since expanded into hand dryers, hair dryers, bladeless fans plus other innovative bits and bobs. Not everything is a success as your correspondent can recall an ill-fated and costly excursion into washing machines in the early 2000s but generally speaking it is unwise to bet against the company. It is reported that Dyson has been working on battery technology for the past eight years and electric vehicles for the past three.

Regardless of your view about the logic of this rush towards gradual electrification of the world’s motor vehicle fleet it does appear to have built up unstoppable momentum. Politicians embrace it enthusiastically. It is now rare for a month to pass without another manufacturer announcing an electric vehicle initiative. But it is even rarer to find a totally new entrant into the automotive market given its inherent risks and the vast capital sums involved. Just ask Elon Musk about both aspects. We await further developments.

And so to the markets.

In the U.S. the Dow Jones fell by 5.2% in October whilst the S&P 500 dipped by 6.9%. Year-to-date both indices are marginally in positive territory thanks to a rally on the final two days of October. Other key equity markets performed as follows: UK: -5.1%; Australia: -5.7%; Germany: -6.1%; Canada: -6.5%; Italy: -7.1%; France: -7.1%; Singapore: -7.4%; Japan: -9.1% and Hong Kong -11.0%. In Emerging markets there were some sizeable falls: South Korea: -12.0%; China: -11.3%; Taiwan: – 10.6% and Mexico -10.6%. Year-to-date the Chinese market is down 20.8% (all local currency MSCI price indices). The ‘World’ MSCI U.S. dollar price index fell by 7.4% in October and is down 3.8% year-to-date.

Turning to government bond markets there was very little excitement over the month. The U.S. 10-year bond yield firmed slightly to 3.16% compared to a September close of 3.06%. UK and German 10-year yields fell marginally whilst Italian yields rose and Canadian, Australian and Japanese yields circled close to their September 30 levels (source: Thomson Reuters Datastream).

All the October action of note was in equities.

 

 

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