A seeming rapprochement between the two powers on the Korean Peninsula was the best news to come out of April. Let’s hope it is not yet another example of North Korea leading the Western powers in a merry dance but instead leads to a genuine peace, nuclear disarmament and economic and political cooperation. Sadly, good political news did not come in twos as the civil war in Syria continued in its ugly fashion. International tensions in the region remain high.
In the U.S. the quarterly corporate profit reporting season swung into action with the standard ‘gaming’ of the numbers (beating ‘guidance’) in evidence. The Trump tax cuts boosted after-tax earnings and undoubtedly enhanced many CEOs’ pay-packets. In our usual fashion we will await whole-economy pre-tax data as reported to the tax office before commenting on the profit trend. The divergence between one set of numbers and the other is often quite striking.
The International Monetary Fund (IMF) has weighed in with its latest economic projections in its April World Economic Outlook release. World output grew at an estimated 3.8% in 2017 and the IMF is now forecasting growth of 3.9% in both 2018 and 2019. This is an improvement of 0.2% for both years relative to its October 2017 forecasts. The main contributions to the improvement come from the U.S., eurozone and Japan. In aggregate, the advanced economies are forecast to grow at 2.5% in 2018 and 2.2% in 2019 whilst the emerging market and developing economies are projected to expand at 4.9% in 2018 and 5.1% in 2019. In the latter category significant improvements are expected in Brazil and Mexico although their growth rates will remain modest compared to the forecasts for China, India and the Asean-5 (Indonesia, Malaysia, Philippines, Thailand and Vietnam).
Over the medium term (five years) the IMF projects the growth rates of the advanced economies to moderate to 1.5% whilst the emerging market and developing economies are expected to maintain aggregate output growth of around 5%.
The IMF cautions: “Upside and downside risks are broadly balanced over the next several quarters, but risks farther down the road are skewed to the downside. With still-easy financial conditions and persistently low inflation that has required protracted monetary policy accommodation, a potential further build-up of financial vulnerabilities could give way to rapid tightening of global financial conditions, denting confidence and growth. The support to growth that comes from pro-cyclical policies … will eventually need to be reversed. Other risks include a shift toward inward-looking policies that harm international trade and a worsening of geopolitical tensions and strife.”
Global debt levels prompt warning
In its separate Fiscal Monitor the IMF focuses on debt and reports that global debt is at an historic high, reaching a record peak of U.S. $164 trillion in 2016, equivalent to 225% of global GDP. Three countries – China, Japan and the U.S. – account for more than half of the total. The world is now 12% of GDP deeper in debt than the previous peak in 2009.
At the general government level debt to GDP ratios are forecast by the IMF to moderate or remain much the same in all advanced countries other than the U.S. The IMF calculates the U.S. general government gross debt to GDP ratio at 107.8% in 2017 and projects it to increase to 116.9% in 2023. Amongst the advanced economies this puts it only behind Japan and Greece (both expected to have gently falling debt ratios over the next few years).
Of great concern is that implicit liabilities relating to pensions and health-care spending are excluded from the debt numbers. In the advanced world the average debt to GDP ratio doubles when these are included. That’s enough to make the teeth rattle.
The IMF’s debt sustainability analysis identifies the critical debt thresholds – beyond which debt sustainability is put at high risk – as 85% of GDP for advanced economies and 70% of GDP for emerging economies.
As worrisome as government debt levels are it is nevertheless the private sector that holds the lion’s share (approximately 70%). The IMF comments: “If left unchecked, the private sector is vulnerable to an abrupt deleveraging process and ultimately a financial crisis. In the event of a financial crisis, a weak fiscal position increases the depth and duration of the ensuing recession, as the ability to conduct countercyclical fiscal policy is significantly curtailed.”
Regular readers will be well aware of our constant fretting over the accumulation of global debt at a faster rate than output growth. The IMF makes the situation perfectly clear. We must get a handle on debt otherwise it will bury us all in a spectacular downturn (our words).
An eye on proxies
Oil continued in the news during April as effective supply management by OPEC countries and Russia maintained a buoyant price level. Brent crude averaged around U.S. $72 a barrel over the month, up from U.S. $50 a year ago. At the beginning of 2016 the price was as low as US$30 a barrel. A rising oil price is a tax by another name. It diverts expenditure from other areas. It is having a marked impact on the non-durables component of retail price inflation in almost every country.
In the U.S. the 10-year Treasury bond yield crossed the psychologically important threshold of 3% during April (the first time since the end of 2013). It closed the month just a hair’s breadth below 3%. We doubt it will stay there long. The ‘Fed’ appears almost certain to raise rates at least twice more during 2018 and U.S. inflation seems likely to remain firm. The latest data from the U.S. Labor Department indicates wage and salary growth is surprising on the upside.
The era of absurdly low borrowing costs, driven by the unorthodox interventions of central banks, is obviously much closer to its end than its beginning. The U.S. Treasury bond has no global parallel – its yield is the fulcrum around which much of the world’s cost of borrowing pivots. Interest rate risk, for the first time in many years, should now form a central part of the work of the world’s investment and credit analysts.
Whilst on the subject of central banks it is worth noting that the European Central Bank and the Bank of Japan now have bigger balance sheets than the U.S. Federal Reserve. At the end of 2017, the respective amounts were U.S. $5.29 trillion, U.S. $4.62 trillion and U.S. $4.45 trillion. (Source: IMF). The Fed’s balance sheet stopped expanding 3 years ago and plans have been put in place for its gradual shrinkage. No such plans are yet in place for the other two monoliths but it must happen. If you keep your foot hard on the gas for many years even the smallest reversal of pressure can have a profound impact on the markets.
Italy leads world equity markets
World equity markets generally performed strongly over April although the majority remain lower than their January 1st start-points. Expressed in U.S. dollars the MSCI EAFE price index rose by 1.9% whilst the MSCI ‘World’ price index rose by 0.95%. In local currencies, again utilizing MSCI price indices, the best country performers amongst developed markets were: Italy (+7.1%); Singapore (+6.6%); UK (+6.3%); France (+6.3%); Finland (+4.8%); Australia (+4.1%); Ireland (+3.8%); Spain (+3.8%); Japan (+3.6%) and Norway (+3.5%). Interestingly, the US market only gained 0.3% over the month and is slightly down since the start of the year – despite the much hyped quarterly corporate profit numbers. We note that the term “peak-earnings” is surfacing in more and more commentaries when referencing the medium-term U.S. profit outlook.
At the benchmark 10-year level most government bond markets witnessed rising yields over the month. The U.S. yield rose from 2.74% to 2.95%; UK from 1.35% to 1.42%; Japan 0.03% to 0.05%; Germany 0.05% to 0.06%; France 0.73% to 0.79%; Canada 2.09% to 2.31% and Australia 2.59% to 2.76% (Source: Bloomberg). The rising U.S. tide is lifting all boats although it is remarkable that none of the other major markets currently experience yields as high as the U.S. Even the Spanish, Portuguese and Italian 10-year yields are lower than the U.S. We wouldn’t bank on this being a permanent feature.
The MSCI EAFE Index is designed to represent the performance of large- and mid-cap securities across 21 developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada. The MSCI World Index is designed to represent the performance of large and mid-cap stocks across 23 developed markets.