The month’s news centered around the rise, rise and still further rise of the US stock market to previously unachieved heights and political events in Japan, China, New Zealand, Spain, and Austria (plus the usual shenanigans in Washington DC).
U.S. stocks reach new heights
Let’s start with the US stock market. We are witnessing strong upward momentum in share prices but the reality is that corporate profits have been growing at a slower pace. This has led to a significant rise in the market multiple (price earnings ratio). For example, the PER on the S&P 500 index has risen from around 15 five years ago to 23.3 today. We have examined whole-economy pre-tax corporate profits on a quarterly basis for the last five years (to Q2 2017 – latest data available) and find that over the full five-year period profits have risen by an aggregate of 6.5%; over four years they are up by 5.1%; over three years they have fallen by 1.2%; over two years they are down by 2.4% whilst over the last twelve months they are up by 6.3%. The quarterly profit peak was back in Q4 2014.
This is hardly a picture of rampaging profit growth yet market participants keep piling in for the same reason they always do – they expect the market to be higher tomorrow. The same psychology works in reverse – in a market crash they keep piling out as they believe prices will be lower tomorrow.
We can’t tell you when the US market will stop going up. What we can say with certainty is that there will be an awful lot of disappointed participants if corporate profit expansion doesn’t start to move at a faster pace. And that’s where we begin to get skeptical. We note that profit For professional investors only margins peaked well above their long-term average in Q3 2014. Since then employee compensation as a share of corporate revenue has been very gradually rising from its all-time low (data since 1950) and profit margins have fallen commensurately. We would not be shocked to see this trend continue.
Revolving politics and the Catalonian putsch
For those who missed it New Zealand had a general election on 23 September and when the government finally took office during October it was the loser sitting in the seat of the Prime Minister. The incumbent National Party won 44.4% of the votes whilst the main opposition, the Labour Party, won 36.9% of the votes. Yet it is Labour now in power thanks to the support of the NZ First Party which polled just 7.2% of the votes and the Greens (6.3%). For his “trouble” the leader of the NZ First Party (Winston Peters) has been handed the Deputy Prime Ministership and two key portfolios: Foreign Affairs and State-Owned-Enterprises. Not bad for a fellow with only 7.2% of the voting public behind him.
This is an extraordinary turn of events given that the NZ economy has been performing well. If measured over the last five years and using GDP growth as a yardstick only South Korea, Singapore and Sweden have pipped it amongst the advanced economies. Over 10 years an equally slim number have beaten it in the growth stakes. Coincidentally, the now-ousted National Party was in power for nine years. Not only has the country been growing satisfactorily it is running a budget surplus (how many can boast that?) and net public debt has shrunk to 38% of GDP. The unemployment rate fell to 4.8% in Q2 2017 – down from 6.7% five years ago. It is now at the lowest level since 2009. The employed labor force is at an all-time-high of 2.5 million.
The new Prime Minister (Ms Jacinda Ardern) has labelled New Zealand’s capitalism a “brazen failure” whilst promising a variety of spending initiatives and foreshadowing plans to cut back on immigration and overseas real-estate investors. Whilst we don’t want to be accused of rushing to judgement on a new government one thing we do feel secure in saying is that New Zealand’s budget surplus is in greater jeopardy with this administration than the previous.
The putsch for independence of the Catalan region from Spain is nothing new – it has been going on for the best part of a century and some claim even longer. We have, however, now reached a new crisis point and the situation remains fluid – which is something of an understatement. The region is relatively prosperous with 16% of Spain’s population whilst accounting for around 20% of its GDP. It is the country’s biggest exporter.
The central government has now taken direct control of Catalonia and scheduled an election for the regional parliament on 21 December. To-date all this has done is provoke even more civil unrest. The stoush is proving a bonanza for constitutional lawyers. We have no insight as to where this is heading but it is clear that with passions on both sides of the debate roused the “solution”, if there is one, is unlikely to quench the fires for long.
Austria held an election on 15 October and 31-year-old Sebastian Kurz, leader of the conservative People’s Party is set to be leader after his Party won support of 31.5% of the voting public. Mr Kurz is discussing coalition terms with the far-right Freedom Party which won 27.4% of the vote. He has been leader for only a brief five months and with his youthful looks and persona has achieved almost pop-star status. A key part of his platform is a reduction in immigration, particularly refugees, which will create tensions in many parts of the EU.
China conducted its 19th Party Congress during October and it reinforced (and added to) the power of President Xi Jinping whilst emphatically affirming the one-party authoritarian state – a “vibrant Marxist governing party” in Xi’s words. In his lengthy address the President frequently referred to the importance of the party retaining “control” – over virtually everything. Those hoping for greater liberalization and a bigger role for the “market” were disappointed. It is a none-too-subtle revision of his publicly stated views when he first assumed office in 2012.
The President acknowledged many of the “issues” facing the country during his speech and spoke about his “road-map” through to 2050. He sees China playing a more important role in world affairs and interestingly made a point of saying that the country would become a manufacturer of “quality” (not quantity).
China-watchers are in typical disagreement over where the country goes from here given the “known-knowns” – such things as rapidly deteriorating demographics, the immense and growing debt pile, serious water and air pollution, accelerating income inequality, corruption, strengthening military ambitions and so on. We, however, don’t side with those who believe China’s economic Armageddon is imminent. It hasn’t paid to underestimate the country since it gained entry to the World Trade Organisation in 2001. It is now the biggest trading partner of every other country in Asia and the biggest trading nation in the world. These are quite extraordinary facts when account is taken of how recently in economic history such prominence could hardly have been imagined.
Certainly growth has slowed from the high average levels of the last 30-40 years and it is inevitable it will slow further but it should still end up the world’s largest economy (measured by nominal GDP) by the middle of this century – and perhaps quite a bit sooner. Make no mistake, we are not enthusiasts for the all-powerful status assumed by President Xi and his seeming retreat from the market mechanism but we will give him the benefit of time – something the Chinese measure in decades in marked contrast to the short election cycle in western countries.
In Japan, Prime Minister Shinzo Abe has retained office in a landslide election victory. He has secured a two-thirds majority in the lower house of parliament. There is no doubt that North Korea’s recent belligerence played a leading role in voter preference for his party.
It will now be interesting to see if Abe moves to try to amend the country’s pacifist constitution (drawn up after WW2). Article 9 states that “Japanese people forever renounce war as a sovereign right of the nation” and promises that “land, sea and air forces, as well as other war potential, will never be maintained”. Of course this was subtly worked–around during the Cold War when the term “Self-Defense-Forces” was adopted with U.S. backing.
Abe will need to weigh his options carefully as it believed that any change in the constitution will not be popular and could quickly lose him the support he has so recently gained.
Global growth forecasted higher
The IMF released its latest half-yearly economic update during October forecasting that global growth will amount to 3.6% in 2017 and 3.7% in 2018. These projections are both 0.1% higher than the forecast released in April. The US and UK have received downward revisions whilst Japan, emerging Asia, emerging Europe and Russia have been revised marginally up. The IMF comments: “While the baseline outlook is strengthening, growth remains weak in many countries, and inflation is below target in most advanced economies…and while short-term risks are broadly balanced, medium-term risks are still tilted to the downside”.
This is the most broadly-based synchronized economic upswing since, dare we say it? – 2007.
The IMF is particularly concerned about debt (hear, hear) and calculates that in the G20 countries gross non-financial debt to GDP (household, corporate and government) amounted to 209.7% in 2007 but 235.6% by the end of 2016. In other words, debt accumulation continues to outpace economic growth. Amongst the nine major advanced countries the only one to have a lower total debt to GDP ratio than in 2007 is Germany. It doesn’t take much of a memory to recall why the world economy got into such an economic tizz just a decade ago but it seems that selective amnesia must be at play.
Stock markets were strong over the month. Utilizing MSCI ‘price’ indices to 30 October and expressed in local currencies the leaders of the global developed country pack were: Japan +6.0%; Singapore +5.3%; Austria +4.6%; Norway +4.1%; Australia + 4.0%; Germany +3.0%; Denmark +3.0%; France + 2.8%; Canada +2.5%; Belgium +2.3% and USA +2.1%. On the other hand negatives were recorded by: Israel -4.4%; New Zealand -1.9%; Portugal -1.7%, Finland -0.5% and Italy -0.1%.
Of course a month is a tiny blip and if we drag the measuring stick out to ten years by far the best performance has been achieved by Denmark and the United States (annualized market returns of 7.4% and 5.4% respectively – excluding dividends). A surprisingly large number of markets are still registering negative performance over ten years.
Bond markets showed no decisive trend over the month with some benchmark 10-year yields up and some down. There is general confusion about where inflation is heading. Even Janet Yellen recently publicly wondered whether her “understanding of the forces driving inflation is imperfect”. So there you have it – no one really knows whether inflation is headed higher or lower. If nothing else economics is a humbling science.
Pyrford is registered as an investment adviser with the Securities and Exchange Commission and is a wholly-owned subsidiary of BMO Financial Group.