As we near the final months of 2018 it is clear that we are less upbeat now than at this time last year. The surprisingly strong and synchronised economic growth which we observed in 2017 – with major blocs enjoying rising share prices in tandem – has now, by the later stages of 2018, changed. Synchronisation has ended, and divergence is the new theme.
The backdrop however is positive: global growth remains robust. China’s 2019 growth forecast, even after a modest downgrade, is 6.2%; and the global economy is set to deliver a solid 3% next year. These are reassuring figures.
But those global averages mask a huge and widening variance. Growth in Europe and Japan has been disappointing, for example, with exports appearing to weaken. And an increase of trade tensions (see below for more on this) casts a wider shadow on these markets.
On the other hand we see the striking continued success of the US. While other regions slow, growth in the US powers on, driven in part by the fiscal stimulus provided by President Trump’s spending and tax cuts for individuals and businesses.
Over the course of three years this is worth more than $1 trillion. As a consequence, US unemployment remains extraordinarily low and measures of consumer and small business confidence are higher than at any previous point in the last decade.
The theme of divergence is playing out not merely in economic growth but also in corporate earnings, interest rates, currencies and equity markets. In the first eight months of 2018 the S&P 500 rose by almost 10%. The rest of the world went in the other direction: global equities excluding the US fell 4.4%. The UK has seen significantly faster earnings growth which, has on average, flatlined elsewhere in the world.
Interest rates too are parting ways. The European Central Bank has not yet raised rates at all in this cycle, and is only forecast to start raising rates in 2019. The Bank of England’s Monetary Policy Committee – whose hands are somewhat tied by the unknowable future shape of Brexit – is not expected to raise rates again until May 2019. On the other hand, by the end of 2019 the US Fed is expected to have increased rates 10 times in the same cycle.
In turn the US dollar has strengthened, hurting emerging market bonds and equities and souring sentiment in these areas.
We see some evidence of inflationary pressures gathering force: producer prices are rising, for example, and wage growth is inching upward in major economies. The former is usually a reliable predictor of rising consumer costs. That said, we do not see inflation galloping away. Our view is of a gentle pick up in price growth sustained over coming years.
We are very long and late into this bull market - more than 100 months, in fact. But valuations on a price/earnings basis are, in many markets, now beginning to come down to more reasonable levels. In the US, previously dizzying price/earning’s have been lowered by rapid earnings growth outstripping share price rises.
To put these gargantuan numbers in context, the mere increase in Amazon’s value during the first nine months of 2018 equates to approximately twice the entire value of global banking group HSBC.
It is a markedly different story elsewhere. In emerging markets, in many cases earnings growth has been coupled with a fall in share price, resulting in a dramatic re-rating. As a result the p/e’s for Chinese equities, for instance, are currently at the low end of their 10-year range.
Despite observing the potential opportunities we remain neutral on equities overall. While we have cited here the positives of sustained global growth, modest rate increases and improving valuations, these are balanced by the risk of escalating trade tensions, political risk as outlined below in several quarters and the outside chance of a more rapid uptick in inflation.
We think the further escalation of trade tensions poses one of the biggest risks to global growth, and the harm could manifest itself in several ways. Trade activity in general could reduce, resulting in asset values falling, as has already happened to Chinese equities. Investment could fall as uncertainty increases, hitting certain sectors – including technology – particularly hard. We could see damage inflicted on supply chains, too, with Asia and China worst affected. Another unwelcome consequence would be a spike in inflation caused by tariffs.
And trade tensions are not the only political dangers at large. Brexit anxieties are intensifying, understandably, as the UK’s departure from the EU poses risks not just for the UK but for other major European economies and companies.
The Italian budget has again focused attention on the problems of European sovereign debt. We do not think there is any immediate peril: but the scale and cost of Italy’s debt, combined with the country’s rapidly ageing demographic, is a sobering reminder of the fragility of the European project.