Boom or bust?
Economies don’t remain in a recovery or growth phase forever and the global economy is nearing 10 years of strong growth. “Will the economic cycle go bust soon or will the boom continue?” was the question which the speakers addressed at the recent adviser-focused Graviton Investment Close-Up event. And, should the next global recession interrupt this extensive period of expansion, will stock markets necessarily follow suit?
From stagnation to reflation
Rob Oellermann, CIO of Tantalum Capital, sketched the economic cycle we’ve seen over the past decade. “After the financial crisis in 2008 we had low inflation and low growth. The environment was negative for equities, positive for developed market bonds and negative for commodities. Over the last 10 years we migrated from this stagnation point through somewhat of a goldilocks phase (on which SA largely missed out due to our political environment). And then we moved quite far into this reflation phase: positive for equities, negative for developed market bonds and positive for commodities.” The question investors now have is whether we’re about to move into a stagflation phase, which is negative for equities, negative for bonds and positive for commodities only.
At the end of last year strong synchronous growth was the experience across the US, Europe, China and certain emerging markets (EMs). But in 2018 the tide moved against EMs, while US GDP is still strong, boosted by the energy complex, tax cuts and fiscal expansion.
Carmen Nel, economist and macro strategist at Matrix Fund Managers, sees growth as having peaked in 2017. The peak was the result of several factors coming together: the high volume of credit that China injected into the system in 2015/16, and the Brexit vote triggering easing from the BoE and delaying a rate hike from the Fed. Nel sees a continuation of synchronised growth in the near future, but at lower levels than 2017 due to lower productivity, the Fed hiking rates, China trying to degear its economy, and the ECB preparing to taper its quantitative easing.
The US yield curve has never been wrong
Both Oellermann and Iain Power, CIO of Truffle Asset Management, expressed the view that “expansions do not die of old age.” In the US, every recession has been preceded by a yield curve inversion. Since 2014 The US yield curve has flattened dramatically, meaning the gap between interest rates on 2-year and 10-year US government bonds is shrinking. Oellermann noted that typically there’s about a 20-month leeway before a recession and about a 16-month run before the turn of the equity market cycle. “The yield curve is telling us it’s late in the day, but it’s not midnight,” said Oellermann.
But an inverted yield curve does not necessarily lead to a recession. Power held the view that either US growth will slow down or long-term rates will move higher, and he sees the latter happening.
Many of the usual suspects are absent
Oellermann pointed out that growth cycles normally end with a point of excess. The usual suspects are overspending, leverage, overconfidence, M&A or listings booms, to name but a few. But durable goods expenditure in the US has not recovered at all since the financial crisis. Residential investment in the US is not in excess. Corporate leverage in aggregate is not problematic (neither was it before 2008). Household leverage is typically low (lower interest rates do mean a lower servicing ratio, though) and “there’s no particular point of stress,” said Oellermann. “In EM in the private sector, we’re seeing no signs of stress, except in China, where we’ve seen dangerously high levels of borrowing.” The error of overindebtness is not being made at a corporate level. Could it be at a central government level?
But keep an eye on government debt levels
Power also stated that he’s seeing none of the imbalances building up in the system, such as high levels of debt and sub-optimal investment, for example roads leading nowhere and empty cities, except in China. “The problem with China is that it’s a centrally controlled economy. We’ve been concerned about China for a few years now, but with a centrally controlled economy sub-optimal investment and high debt could continue for a long time.”
Ten years after the financial crisis we are once again keeping an eye on debt. Nel listed all the “dominoes” that recently fell: Italy, Argentina, Turkey; all eyes are now on Brazil and SA has also been mentioned as a vulnerable country. “That’s certainly in contrast with global investor sentiment towards SA,” Nel said. Households across the world have largely degeared over the past 10 years. But the level of government debt has increased. According to Nel the key countries to watch in terms of a debt implosion are China, Italy and Brazil. For SA, Brazil falling is a big risk because that would lead to significant contagion.
Trade wars and populism are increasing volatility
Even if economies are still showing positive growth, stock markets may – in the short term – turn negative because of increased uncertainty.
For Oellermann the surprise of the year has been the uncertainty created by the trade war tariffs. But he does not foresee a trade war leading to negative global growth. “Though China is vulnerable, its economy is centrally managed and being managed for 5-6% growth. We saw a surge of debt but it’s stabilised.” According to Oellermann, strong manufacturing growth in China in the second half of 2018 will somewhat mitigate the effect of US tariffs in the short term.
Although the Trump administration is causing a lot of uncertainty with its trade policies, Power does see the merit in the US pulling some levers to obtain free access to China for US companies. “Chinese companies like TenCent and Alibaba have had free reign and it’s impossible for US companies to enter the market. Yet, China wants the best of both worlds.”
Power noted that there have been fertile grounds for populist policies to emerge. “Not only in the US but worldwide, as we’ve just seen with the rise of far-right Bolsonaro in Brazil. With the rise of more populist regimes across the world, we’re likely to see the rise of uncertainty.”
Inflation risk is rising
Oellermann observed that US wage inflation is on the rise and, as a result, the Fed has embarked on quantitative tightening. Markets will respond to whether this path remains predictable or not. “To date, central banks have shown that they ‘get it’. They understand their role in maintaining a balance between growth and batting off deflation. There is nothing that we can see that makes us think that a policy error is around the corner. A policy error will not come from the Fed; it may come from the ECB.”
As far as inflation is concerned, the final “wild card” is the oil price, according to Oellermann. But the US is offloading shale gas to the equivalent of more than a million barrels of oil supply per day. Oellermann therefore sees oil trapped in a range between $60 and $75 – positive for curtailing inflation.
Not “bust”, but slower growth ahead
When looking at the state of the global economy, Oellermann’s conclusion is that the world is still in the reflation phase. “We’re past the goldilocks phase of the global economy but there’s still enough fuel in the tank left for positive growth.”
Neither does Nel anticipate a global recession within the next two years. “But there will most likely be a slowdown. From the recent divergence the economy will convert again, particularly with the US moving closer to the lower growth seen in the rest of the world.” By the end of 2019 the Fed would probably have hiked another four or five times, “giving it at least some ammunition,” said Nel. “The next recession or slowdown would not be sharp but prolonged due to there being less monetary ammunition around than in 2008.”
Because of the tax cuts and the Trump administration is stimulating the economy at the wrong time and almost “emptying the cupboard,” Power expects the US economy to continue to grow and likely divert its growth relative to other world economies. Despite the US yield curve flattening, Power does not see a slowdown happening anytime soon in the US; instead long-term rates will move higher. “The US probably has another three or four quarters of higher than 3% growth left,” said Power.
Small window of opportunity for SA
Rafiq Taylor, head of Implemented Consulting at Sanlam Investments, observed that while the rest of the globe has been expanding, SA has moved to the side line. “Whether we experience a boom or bust will depend largely on the growth in the developed world,” said Taylor.
Nel sees fiscal tightening as the biggest headwind to growth in SA. This year alone we had tax tightening of R40bn – roughly 0.8% of GDP – the equivalent of an almost 200 bps increase in the repo rate. Inflation will remain well contained at 5-5.5% due to lower import pass-through on the back of low demand in the economy. And Asia is still exporting disinflation into the economy. The fact that China has allowed their currency to weaken is actually good news for SA, which imports a significant amount of goods from China. Nel pins the fair value for the rand at R14-R14.50 against the dollar.
Unfortunately, the global economic cycle has matured and when the global economy goes into recession, that will affect us too, warned Power. “We have a very short window of opportunity left while the global economy is still reasonably robust.
“Brazil is worrying us most, because there has not yet been a period of trauma to the Brazilian real that has not affected the rand negatively. Some of China’s unsustainable infrastructure development, such as the recently announced underground train network, is positive for commodities-rich South Africa and could see commodities prices remaining high. That could extend our window period for getting our own structural reforms in place.”
What does this mean for your portfolio?
Predicting the global economy is difficult enough, but knowing how and if the stock market will respond to the end of the global expansion is even harder, Power reminded investors. “Often during a recession a stock market goes up. In the 14 recessions since 1929 markets went up 50% of the time and down 50% of the time.”
That’s why the managers at Truffle stick to that which they can hang their hat on: company valuations. “We focus on instruments delivering income (a high dividend yield in the case of stocks) and not pricing in a rosy price appreciation,” said Power. Currently, the consensus earnings growth forecast stands at 16% in US dollars for the next three years. “We typically get good returns from the stock market in the late cycle of an expansion, as the earnings from companies are generally still strong and pushing up stock prices. So, what we can do from a portfolio perspective is to observe these risks, assess how high they are and either dial up our risk asset exposure or dial it down,” said Power. Truffle also maximises its diversification opportunities.
In the light of their current valuations, Tantalum Capital is overweight global defensive stocks and SA banks and underweight SA defensives, insurers and industrials, according to Oellermann.
Nel said that over the very short term Matrix is bullish on the SA currency and rates, in the medium term a bit more bearish on the currency and bond rates, and over the long term it sees the US dollar cycle turning and giving some reprieve to the SA rand. Nel expects volatility to steadily pick up as the Fed continues to hike interest rates in line with its dot plot.
For Taylor, portfolio construction is not about having the skill to foresee a drawdown, but the patience and discipline to sit it out. “If you believe you have the foresight to predict a drawdown, which asset classes are going to provide you with protection?,” Taylor asked. “Equities have been the most rewarding asset class over the past 90 years. But, as always, make sure your portfolio is diversified.”
The best value emerges at the darkest time
Power reminded the audience that the best returns often come in the twelve months after a recession and the median return of the S&P 500 was 14% after past recessions. “The best value often emerges at the darkest time. Because when it turns, it turns sharply upwards over the course of a few days – you need to be in the game to participate in that upturn.”